Congratulations on starting your own business.
You will have spent some time on thinking about which form of business ownership is best for you and, as you already know, there are 3 types of business ownership: Self-employed, Partnership or Limited Company. If you are self employed, you can still employ other people of course and you will need to take care of their wages, NI and tax. Partnerships are formed where there is more than one person and ownership is shared equally among the partners. There is also a liability in terms of one partner’s debts become the other partner’s debts too.
Which one of these is best for you depends on your needs and your type of business. There is also the question of how much time you have and are willing to spend planning ahead. As your business grows and you have more tax and legal obligations an extra bit of time invested can go a long way.
In this article I am going to talk about limited companies and the advantages of forming a limited company for you. Limited companies are legal entities in their own right which means that only limited companies, not people, are liable for any debts. The company is limited by the number of shares held. Having a limited company allows you to offer different types of shares to shareholders based on their personal tax circumstances. Dividends, the payments earned from share ownership, can also be waived on the transfer of income from a higher rate to a lower rate tax payer, this would save tax.
The limited company also has advantages when it comes to inheritance tax and trading. Even if the business owner dies, the company will still exist so it can carry on trading.It would not therefore be liable for inheritance tax.
You can also claim tax free employee incentives and benefits as the company can claim tax relief. This is not possible if you are a self employed employer.
If you are unfortunate enough for your company to make a loss you can also transfer it and take relief on it from salary and dividends. The condition for this is that 75% of the shares must be kept by the shareholder in the year the loss is made.
If you choose to form a limited company you will have to pay corporation tax, on your profits, in addition to your other taxation liabilities. If your company has less than £300, 000.00 in profits then you will pay corporation tax, on a small profits rate of 20%. This is less than the comparable income tax of rate of 50% and tax savings can be made through limited company status. If the drawings from the business are taken as salary, this may attract the higher taxpayer rate. If drawings are taken as salary, expenses and dividend payments this will reduce the overall tax burden.
Corporation tax is payable to HMRC nine months after your year end which gives you some time to pay it and can help your business liquidity as a result. Make sure though that you put this money aside so that you will have it when it is due. Profits, on which corporation tax is paid, are worked out before dividends are taken for shareholders.
Tax savings are one of the major incentives behind forming a limited company. These tax savings are at their highest when the company is making good profits and the directors/ shareholders do not need to take all that money out each year.
But bear in mind that as a director of a limited company, you are also an employee of the business and need to pay tax on your salary (including benefits in kind, dividend income and other income derived from the company) and operate PAYE and National Insurance contributions for yourself and all employees.
Another tax that you will have to manage is VAT. Value added tax is paid on goods and services in the UK and is paid by the consumer at 20%. As a business owner, you can choose to be VAT registered or not. If your turnover exceeds £77k, you have to register for VAT.
The VAT rate varies according to the item. For items which are standard-rated or reduced-rated for VAT, VAT is charged to the buyer (output tax) by the VAT-registered seller. This VAT is reclaimed by the VAT registered buyer (input tax) after goods and services are purchased. If you are registered for VAT, generally you charge VAT on your business sales and reclaim VAT on your business purchases. The difference between the VAT you charge and the VAT you are reclaiming is the amount of VAT you must pay to HMRC. This can be a little confusing for business start up to understand.
To make things easy for yourself, and if your turnover is less than £150,000, you can use the VAT Flat Rate Scheme. The advantage of this is that instead of working out all your expenses and invoices you pay a % of your gross turnover. The percentage you pay depends on the business sector you work in and in your first year of registration, you can deduct 1%. For example if you are a freelance photographer, your flat rate would be 11% (based on 2011 rates) and in the first year of being registered you are allowed to take off 1%, so this would be 10%.
To give an example then;
You quote a job at £2000 and add VAT this would mean you invoice for £2400. (+ 20% VAT for the customer)
You would need to pay £240 Flat rate VAT to HMRC (10% of £2400)
This means that you get to keep the extra £160! (£400-£240=£160)
The downside is that you cannot claim any VAT back from your business expenses (unless an single item totals more that £2000)
As a business owner, in difficult trading conditions, it is good to hear about ways to reduce your costs. There are still incentives available to your business in the form of allowances, reliefs, incentives as well as tax credits. The Capital Allowance Scheme, for example, gives you tax relief on necessary business equipment, like computers, cars, tools or furniture that you intend to keep. Be aware that if you buy an items on hire purchase, you can claim a capital allowance on the original cost of the item but the interest and other charges that you may have count as business expenses.
You can also claim research and development relief, which can reduce your tax bill or, for some small or medium sized companies, provide you with a cash sum. The aim of the R&D Relief is to encourage greater R&D spending in order to promote investment in innovation. If you need any more information than this article gives you, HMRC have produced an excellent document which is well worth a read. It is called “Working Yourself” and is available here, just double click on the hyperlink →working-yourself
Have a look and happy trading. Below is a case study example of a limited company that specialises in hair extensions. Thanks to Business Link for this video.
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