One of the key decisions to make when starting a business is what kind of structure to choose; and one we find ourselves advising on in the construction industry particularly. In most cases the question is whether to operate as a sole trader (or partnership) or to form a limited company. Indeed, you may already be in business operating as a sole trader and be wondering if you would benefit from incorporating. There are pros and cons for either structure and the question is best approached on a case-by-case basis.
So, let’s consider the sole trader structure. It is simple and straightforward to set up and operate, there are no obligations for compliance filings with the company registration office, and if things don’t work out, there are no complex procedures to wind it up. As a result, your accountancy fees are lower, and you’re under less pressure regarding deadlines and ensuring compliance. For many small businesses at start up stage, particularly if there is any doubt about the longevity of the business, a sole trade is the advisable option. If all goes well, you may choose to incorporate the business down the line, if not you will have avoided a lot of expense and hassle in forming and dissolving a limited company.
There are a few points however to consider if you decide to operate as a sole trader. Firstly, from a legal perspective, you are inseparable from the business and as such you are personally responsible for any debts of the business. A second point to consider is the image of your business. Clients have often reported that they find they are perceived more favorably if they operate as a limited company, feel they are taken more seriously and as a result gain more business.
Thirdly, the main difficulty many have with operating as a sole trade is the lack of control over their personal taxation. In this structure you will be taxed on the total profits of the business, regardless of what you have taken as personal drawings. You may wish to reinvest profits in the business, rather than taking it out, but this will make no difference to your tax liability.
With the construction industry in mind, a sole trade structure may best suit individual tradesmen, without or with very few employees, who are not heavily financially invested in their business and prefer not to complicate things.
Now onto the limited company structure. The main disadvantages are additional compliance and therefore higher accountancy fees. There is a need to be organized; the company is entirely separate from you, and you do not use company money for personal expenses. Instead, you become an employee of the company and take a salary. Some also may not be comfortable with the fact that summarized financial results of the business can be accessed by the public. There is a surcharge on undistributed income for professional service companies. While this would not affect many businesses in the construction industry, construction related professional services such as engineers and architects would be liable.
The most significant advantages of a company structure are limited liability, directors pension benefits and taxation control.
Regarding limited liability, your personal liability is restricted to the cost of your shareholding. You are not personally responsible for the company’s debt. It is worth noting that you may not have protection from personal liability if there has been fraud or illegal activity.
Limited companies offer great scope for directors to build up their pension fund – the company can fund a private pension for a director up to a maximum of €2,000,000. The director themselves does not need to contribute from their salary.
Finally, to discuss the main reason many clients wish to consider the limited company structure – tax. We have found that many believe that a limited company will save them on tax. This is not entirely accurate, and the potential tax advantage should be considered carefully.
The standard rate band in Ireland is currently €36,800 for a single person, after which you will begin to pay higher rate tax. For high earners, the resulting liability can be eye watering, and difficult to pay once a year if no provision has been made. So how would this be different in a limited company? Profits are taxable at 12.5%, so on the surface that would appear to be a huge saving. Remember however that you as the company owner, are not entitled to use the company profits for personal use – instead you will take a salary and pay tax through the PAYE system. The salary you choose to take will dictate the amount of tax you pay.
To make best use of a company structure for tax purposes, the owner would choose to take a lower salary than the company’s profits, under the standard rate band for maximum benefit. They would also use the company to make pension contributions for themselves. They could have in mind an exit plan, at which time the accumulated profits could be extracted at Capital Gains Tax rates, possibly even availing of a CGT relief. Many business owners in the construction industry plan for early retirement due to the physical exertion of the work, and from the age of 55 they may qualify for retirement relief from CGT.
On the other hand, if the owner wishes to take all the company’s profits as salary, there is no tax saving. They will pay tax through the PAYE system of an equivalent amount they would have paid as a sole trader. Unless some of the other advantages are appealing, in this case the limited company structure may not be advisable.