Sunday 2 October 2011

Self-Employment vs Limited Company 1 - Overview

When you start a new business, the first question you need to ask yourself is "should I start as a self-employed business or a limited company".

Below are the differences between trading as a self-employed business and limited company:


Income Tax and National Insurance Contributions

Experience tells us that in most cases, trading as a limited company usually give you tax advantages, provided you have the most efficient fund extraction strategy.

If you are self-employed, you are paying income tax and Class 4 National Insurance Contributions on your self-employed profit, as well as Class 2 National Insurance Contributions at a fixed rate of £2.50 a week (for the tax year 2011-12).

If you are running a business using a limited company, your company will pay corporation tax  on the net profit it generates while you pay income tax on the salary and dividend you receive from your company.

Due to the "peculiar" nature of the UK tax system, the combined effective tax rate is lower if you trade as a limited company.  For a detailed  (and rigorous) comparison of tax liability between self-employment and incorporation, please read our next post (Self-Employment vs Limited Company 2  - Tax Liability Comparison).


Administrative burdens

Trading as a limited company generally involves more "form-filling exercise" and hence increases the administrative burdens on your shoulders.

If you are trading as a self-employed business, the only form you need to complete is your Self Assessment Tax Return.  You only need to do it once a year and for some "non-number-fearing" people, it should be quite straightforward.  Generally speaking, all you need to do is to work out your gross revenue and deduct the business expenses from the gross revenue to arrive at a figure for the net business profit.  You then work out your tax liability on the net profit.

If you are not quite comfortable with working with numbers, you may appoint an accountant to do the job for you.

If you are trading as limited company, you will need to do Self Assessment Tax Return for the salary and dividend you receive from your company.  In addition, you need to file a Company Tax Return for your limited company as well as a Company Annual Statutory Accounts and Annual Return with Companies House.  They all have very strict deadlines you need to meet.  Failing to meet those deadines may result in Companies House proposing to strike off your company.  Doesn't it sound scary?

Therefore, people trading as a limited companies usually ask accountants to take care of all accounting and tax aspects of their limited companies for them.


Costs

Generally speaking, it is more costly to run your business through a limited company than as self-employed, in terms of time and money.  Running a limited company involves more paperwork and is therefore more time-consuming.  Your accountants may charge you more if you are trading as a limited company because of higher workload.


Credibility

People tend to perceive a limited company as more credible than a self-employed person and therefore you may need to take that into account when considering whether or not to run a limited company.


Your liability if your business goes bust

One of the consequences of trading as a limited company is that your liability for the company's debts and failure is "limited" (in most cases) because your company is a separate legal entity from you and therefore your company is liable to its own debts.

Your maximum financial liability for your company's debts is the amount of money you put in the company and the chances of your creditors being able to take your personal assets (such as your houses) to settle your company's debts are very slim.

However, if you are a self-employed person, you are personally liable to your business debts.  If your self-employed business goes bust, your creditors can come after you and take your personal assets away to pay off your self-employed business debts (which are your personal debts after all).

Therefore, by incorporating a limited company, you are protected from the risk of your company going bust.


Exit Strategy 

It is easier to implement your business exit strategy if you are trading as a limited company.  Shares in your limited company can be valued with credibility based on the accounts and other documents you have filed with Companies House and other organisations.  The buyers of your company business can assess the past performance of your company and therefore determine the fair value of your company using the formal/official documents you have produced for the company.

If you are running a self-employed business, your accounts are more likely to be produced on an "ad hoc" basis and may look less credible from the buyers' perspective and therefore it may be more difficult to sell your self-employed business.

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