The Decision to Incorporate

March 13, 2022

The end of the year is often a time for business owners to reflect on the year past and the year ahead. One such consideration could be the structure within which one operates their business. At Corvidae, we are frequently asked the question should I incorporate my business?

A solid starting point in addressing this question is to review the owner’s drawings.

If a sole trader is drawing out all the profits to cover their personal outgoings then any proposed change to a limited company is not going to give rise to a tax benefit.

Similarly, if the sole trade business is loss making (and this may be the case, if you are in start-up phase) then incorporation is unlikely to make sense because trading losses arising to an individual can be offset against the trader’s total income or income of a spouse (potentially generating a tax refund).

In this type of situation we would typically advise to defer the incorporation until the business is likely to turn profitable.

A limited company provides a degree of control over cash flow in respect of tax payments. And as a director of a limited company, you are only taxed on the salary that you draw from your limited company in real time (Pay As You Earn). A sole trader however is taxed on his profits (irrespective of what funds are drawn from the business).

The tax rate for trading income is usually 12.5% versus a marginal rate for individuals that can be as high as 55%.

A limited company structure offers more flexibility for raising outside capital e.g. Employment and Investment Incentive Scheme (EIIS), this relief involves a subscription for shares. A limited company pension scheme also offers more tax efficient funding opportunities, and it can provide for tax efficient termination payments, which are available to working company directors who take retirement/redundancy. The above reliefs are not available to a sole trader.

Just to take stock of the above points, if a sole trader does not need to draw all the profits from the business then most likely incorporation will make sense with a view to building up wealth (and protecting same) in a limited company structure.

From a commercial perspective a limited company provides limited liability. This means that the business owner or owners are only responsible for business debts up to the value of their financial investment in the business.