Setting up a business? The key tax considerations
As the owner of a small or medium-sized enterprise (SME), you enter a taxation environment dominated by self-assessment.
As a result, James Abbott, small business specialist at tax adviser Abbott Moore, urges stringent record keeping to ensure you have documentation to provide to authorities if questions ever arise about your financial activities.
“Ideally, HMRC won’t have any need to ask you questions at all, but you don’t want to wait until they come knocking to put an explanation together,” he says.
Sole trader vs. limited company
How much tax your SME incurs depends on which type of business you register as: sole trader (effectively self-employment) or limited company.
“Very broadly, operating as a sole trader or partnership is more straightforward than a limited company. In the case of the latter, you’ll have to fill out many more forms, and there and many more things you’re obliged to put on the public record, not just with HMRC, but Companies House too,” says Abbott.
“Most SMEs are best-served by starting life as sole trader operations, unless your profits exceed £50,000 from day one. Although, you and your business will for the time-being pay less tax as a limited company. In a limited company, you can take a low salary and balance this with dividend payments, saving on National Insurance contributions you’d otherwise incur.”
As a sole trader you only pay tax on your profits. Any money left after taxes is yours, and can be withdrawn from the company as and when you like. In a limited company, any money the company holds once salaries have been paid out isn’t yours, it’s the company’s. As a result, it will be subject to corporation tax of 20 per cent.
Peter Whitehead, senior tax manager at accountancy firm HWCA, notes some SMEs will be obliged to become limited partnerships simply to operate.
“Some customers will insist on only working with limited companies, due to the perception it’s a more substantial entity than a sole trader,” he says.
Capital gains tax (CGT) is not an issue that will affect smaller SMEs, those employing around five people or less.
Abbott explains these SMEs typically don’t have a product to sell, and the business’s capital is the individual or individuals involved.
All SME owners also benefit from entrepreneurs’ relief. Introduced in 2008, it allows business owners to pay an effective 10 per cent capital gains tax rate on the partial or full sale of a business, shares they hold in a company, or any assets sold after a business stops trading. Entrepreneurs’ relief can be claimed on up to £10m in a lifetime.
“Entrepreneurs’ relief can only be claimed by individuals, not companies themselves, and you must have owned a business for 12 months before claiming” Whitehead says.
“You can claim entrepreneurs’ relief as often as you wish, although if you exceed the £10m allowance, the standard rate of 18 per cent applies.”
All dividends you receive as a limited company shareholder are subject to income tax. At present, there are three separate dividend tax rates:
Standard rate tax of 10 per cent, applicable to income less than £31,865
Higher rate tax of 32.5 per cent, for incomes up to £150,000
Additional rate tax of 37.5 per cent for incomes in excess of £150,000
As your company profits have already been taxed, any dividends you draw will receive a 10 per cent tax credit.
“If you’re a standard rate taxpayer, this effectively cancels out any standard rate dividend tax liabilities you would’ve otherwise had, meaning you’ll end up paying nothing,” says Abbott.
While this may seem simple, Whitehead recommends consulting a tax professional to ensure the correct amount of tax is paid, and dividends are appropriately sourced.
Abbott adds: “Beyond the standard rate, taxes on dividends can be confusing. Also, if you run a limited company, you can only withdraw dividends from retained profits. There are significant penalties for people who declare dividends illegally.”
Many choose to share the income of their SME with their spouse. This can be done in a number of ways, but different methods fit different types of SME better.
“If you’re a sole trader, make your spouse a partner in the business. If you’re operating a limited company, make them a shareholder,” Abbott says.
“In both instances, they will receive income in the form of dividends.”
You could alternatively elect to make your partner an employee, whether you are a sole trader or limited company. This approach will open you and your business up to increased scrutiny from HMRC.
HMRC is wary of spousal employment, and will operate on the initial assumption that your partner’s job is purely ceremonial. Consequently, whether your partner is doing a legitimate job in your company or not, their role, and the contributions they make to the business, will be scrutinised thoroughly.
“If your spouse isn’t doing much but receiving a sizeable salary, you’ll encounter problems,” Abbott warns.
“The level of pay they receive must be commensurate with standard rates in the field – if your partner performs admin tasks for example, the typical wage for which is £10 per hour say, then that’s what you should pay at most.”
Whitehead notes there are other risks inherent in making a spouse a partner.
“If you were to split with your spouse, you may not get the chunk of the company you’ve given them back,” he says.
“This means they could continue to receive an income from your business years after your marriage has ended or choose to sell their portion without your approval.”
Click here for part 1: Setting up a business? How professional advisers can save you money