Changing from a soletrade to a limited company

Changing from a soletrade to a limited company

Many people start out in business as a soletrader and once the business is off the ground “graduate” to a limited company. There are various reasons for changing from a soletrade to limited company, some real, some perceived:

  • To avail of lower tax rates
  • Protection of limited liability
  • Banking or investor requirements
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Before deciding whether to or not to incorporate, sole-traders should ask themselves 3 questions:

  1. Are there any legal prohibitions to me operating through a limited company?
  2. Am I prepared for the stricter administration required in the operation of a limited company?
  3. Are there any potential tax pitfalls on transferring my business?
Legal prohibitions

Certain professions are prohibited by law to operate as limited companies. Those I am aware of are solicitors and dentists. I also think there’s a question mark over doctors.

I am aware of doctors and dentists (particularly locums) operating through limited companies in order to get round the whole employer/employee relationship which has recently been a focus area for Revenue. I’ve also heard of cases where Revenue has challenged the legality of dentists operating through limited companies.

If you are a doctor or dentist I would advise you seek expert legal advice before incorporating a company.

Retail pharmacies can operate through a limited company. However, I think there is a question mark over a locum operating as a limited company.

Stricter administration rules

In addition to increased annual reporting obligations limited companies are also subject to strict rules regarding day-to-day transactions.

As a sole-trader you probably withdrew cash from the business as and when you needed it (or had it!). Often in a sole-trade, because you and the business are one and the same, the lines can be blurred between business and personal. While this isn’t necessarily good practice – it isn’t a crime. The only time you may get into bother is if you try to claim a personal expense as a business expense.

Things are different with a limited company. Do you remember Sean Gallagher being questioned over a loan made to him by one of his companies? It was alleged at the time this was a breach of company law. The explanation Mr Gallagher gave was that a cheque was inadvertently lodged to his personal account instead of the company account (and on discovery it was corrected). Why would this be a problem?

Under company a law, a company cannot make a loan to a director in excess of 10% of the net assets of the company. This means that there must be strict controls over payments to directors, and they must be made in accordance with company law and/or have the appropriate tax deducted.

Of course none of this would matter for a sole-trader. Provided all income is shown in the business accounts there’s no law against lodging a business cheque to your personal account.

If the company has plenty of reserves it can make loans to directors (within the 10% rule). However, the company must pay income tax at 20% on the grossed up amount of the loan. It can claw this back when the loan is repaid.

Tax on transfer of a business

Who would’ve thought it? It’s my business, it’s my company how can any tax problems arise on the transfer of one to the other?

Quite simply the company is not you – it is a separate legal person.

There are 2 ways to transfer the business:

  1. Sell the business to the company in exchange for cash or an IOU – Capital gains tax (CGT) on the sale, and stamp duty on certain assets.
  2. Sell the business to the company in exchange for shares in the business – deferred capital gains tax, stamp duty on certain assets

The exchange for shares is usually considered the most tax efficient, but it may not always be the case. Firstly, it is a deferral of tax. The tax may be payable at some later date. Secondly, to avail of the deferral ALL business assets must be transferred. This can be problematic where the business premises is not owned by the sole-trader and no formal lease is in place.

Some people prefer to take the CGT hit up front and get it out of the way (this may not be as popular now as CGT rates have increased from 20% to 30%). This way can also give more flexibility and measures can be taken to reduce the tax impact.

Timing

You also need to consider the best time to cease the sole-trade and transfer the business to the company.  If your sole trade business has an accounting year-end other than 31 December, it can be more tax efficient to cease the trade shortly after the 31 December.  This has to do with the cessation of trade rules and timing of profits.  If your accounting year-end is 31 December, though, you don’t need to worry about this.

But don’t be put off…

…just think carefully before taking the plunge.

If you do intend switching you should have a clear cut-off date for when the sole-trade ceases and the company commences. Don’t do it piecemeal . This is very important in ensuring that the two entities are kept entirely separate.  Get off on the right foot by getting the administration right from the start.

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