There are a number of ways of entering business, as a sole trader, a partnership or a limited company. Each structure has benefits and shortcomings which the owner should be aware.
The choice of legal structure for your business often depends on personal tax circumstances, financial resources available, business risks and the owners plans.
Some of issues to consider include:
- When to trade as a sole trader and when to trade through a company.
- The applicable tax rate.
- Tax registration, payment and filing returns.
- Close company issues.
Trading as a sole trader or through a company
When to incorporate a business generally depends on the priorities of the business owner, his/her expectations for the future, the size of the business and the type of business involved.
A rule of thumb is that a business should be incorporated only when it generates more taxable profits than the owner needs for his/her annual income. This logic is still valid however there are further specific issues that need to be considered. These include the following:
The profits of a sole trader can be taxable at over 50%, whereas the profits of a company are taxed at either 12.5% (trading income) or 25% (passive income e.g. rental income or deposit interest). The 12.5% corporation tax rate is appealing – however one must also consider the potential exposure to the close company surcharge if trading through a company and the problem of extracting cash from the company in a tax efficient manner.
Costs of the incorporation
An existing sole trader needs to be aware that the transfer of a trade from the sole trader to a company (a completely separate entity) can crystallise tax liabilities e.g. capital gains tax. By availing of tax relief’s and tax planning – businesses can potentially incorporate without triggering tax costs. For example, Section 600 Taxes Consolidation Act 1997 allows a bona fide transfer of assets from a sole trader to a new company in exchange for shares in the new company without a charge to capital gains tax arising. However stamp duty of 6% may be payable by the company on the acquisition of the goodwill of the existing business.
Long term plans of the sole trader
A business could be more attractive to either future purchasers or children (should the sole trader wish to give it to them) if it is packaged as a company. The stamp duty exposure on the purchase / gift of an incorporated business might be much lower than on the purchase / gift of an unincorporated business.
Non tax issues
Sole traders also need to consider some non tax issues such as:
- The attraction of having limited liability.
- More companies can now avoid the obligation of an annual audit by their accountant as the definition of a small company for audit purposes has been extended significantly.
- The increased legal responsibilities on directors, shareholders and companies have made sole traders wary about incorporating.
The applicable tax rate
It is important that when the company is formed the correct tax rates are applied to its profits.
If the company is managed and controlled from Ireland and is engaged in a trade other than an “excepted trade” it is entitled to avail of the 12.5% corporation tax rate.
If it is not trading then its taxable income is subject to the 25% corporation tax rate.
The tax treatment of allowable deductions and the use of losses can give significantly differing results depending on whether or not the company is trading.
Companies that carry out excepted trades must pay corporation tax at the 25% rate on their profits irrespective of their scale.
Excepted trades include certain land dealing activities and income from working minerals and petroleum activities.
Passive income (i.e. non trading income) earned by trading companies e.g. deposit interest or rental income is taxed at the 25% rate.
Tax registration, payment and filing returns
A form TR2 is used to register the company for corporation tax, PAYE and VAT. Registration should be done as soon as the company is formed and is about to commence its activities.
Tax payment and filing
A company must submit a return of its profits and chargeable gains to Revenue nine months after the end of the accounting period and no later than the 21st day of that month. If a company fails to submit its return on time, there are penalties by way of surcharges.
A delay will also trigger a restriction of a large number of reliefs and allowances claimed by the company.
Companies are now obliged to pay 90% of their tax liability for an accounting period as preliminary tax in one installment on a day 31 days prior to the end of the accounting period, but no later than the 21st day of the month in which that day falls.
Companies that qualify as “small companies” have a choice on whether to base their preliminary tax calculation on 90% of their expected corporation tax liability or 100% of the liability of the previous accounting period.
Most Irish companies are close companies and are therefore affected by anti avoidance rules specifically targeted at them. It would be highly unlikely that a sole trader expecting to incorporate a business could avoid the restrictive close company provisions.
Disadvantages of being a close company
Certain benefits provided to participators (e.g. shareholders and their familes) are treated as distributions. This means that no corporation tax deduction is available to the company for the expense and it must apply 20% dividend withholding tax to the deemed distribution payment.
A close company surcharge of 20% of a company’s distributable rental and investment income is imposed if the company has not made a distribution of the relevant income within 18 months of the end of the accounting period.
If the close company is a professional services company e.g. an engineering company a surcharge of 15% may arise on half the distributable trading income of the company if a distribution is not made within the same time period.
Close company surcharge planning
No surcharge applies if there are no distributable reserves in the company.
Liquidations of close companies can be complex, and extreme care is needed if the company is exposed to a close company surcharge, especially in the case of voluntary liquidations. Once a liquidator is appointed, such companies cannot make distributions. Therefore a close company about to go into liquidation could consider paying a dividend (if necessary) before appointing the liquidator.
Pension contributions and additional or increased salaries by a service company on behalf of the directors also reduce the company’s surcharge exposure as they reduce the overall taxable profits.
In conclusion we believe that sole traders should seek expert tax advice as part of their decision making process to ensure as many pros and cons as possible are carefully considered in advance.
If you require any further advice or assistance with setting up a business please contact Niall Beggs on 01 210 7895 or firstname.lastname@example.org.