Starting a business: sole-trade vs limited company

One of the most important decisions to be made when starting a business is what legal structure to adopt: sole-trade/partnership or limited company?

Both have advantages and disadvantages. Each business’s circumstances must be examined in its own right as what may suit one set of circumstances may not suit the next.

Firstly we must explain the difference between the two:

Sole-trade

An individual in business in a personal capacity. The assets and liabilities of the business are those of the individual personally. This means a sole-trader has unlimited liability. The sole-trader can be sued personally for anything the business does. If the business fails the individual is liable for all the debts of the business.

Limited company

A limited company is a legal entity in its own right. It can sue or be sued. The “owners” of a company are its shareholders. If the business fails, the shareholders can only lose the money they paid for the shares. This is limited liability, ie the shareholders’ liabilities are limited to the cost of their shares. The shareholders appoint directors to run the company. The directors are bound by the Companies Acts to run the company in a certain way. If they don’t and the business fails they can be held personally liable for the company’s debts.

Limited company key advantages
Limited liability

Traditionally this was one of the biggest advantages of trading through a limited company. As stated above a shareholder’s liability is limited it his/her shares whereas a sole-trader can lose everything.

Absolute limited liability, however, is becoming less and less achievable. Banks will usually require directors to personally guarantee borrowings of the company; landlords often require directors to guarantee leases; where a company is would up and owes PAYE on behalf of employees Revenue can deem PAYE paid on behalf of directors as being that of the employees. Leaving the directors personally liable for taxes already deducted from their salaries and paid over to Revenue.

Lower tax rate

A corporation tax rate of 12.5% has made taxation arguable the main motivation for business people to trade through a limited company. When you compare the 12.5% rate to the marginal income tax rate of 52% (Tax 41%+PRSI 4%+USC 7%) the benefit is obvious. The benefit is even greater if you anticipate profits in excess on €100,000: 10% USC for sole-traders versus 7% for proprietary directors.

However, cash must be extracted from the company and there are limited means of doing this tax efficiently. Dividends and salary are chargeable to income tax so the 12.5% has little relevance. Where it will be beneficial is if the company is making more profits than the directors require in salary. Any excess profits will be taxed at 12.5% and invested back into the business. A sole-trader’s entire profits are subject to income tax regardless of what cash is taken out.

Inward investment

It is much easier to manage investment in a company than a sole-trade. A sole-trader wanting to attract outside investment will have to enter into a partnership (although the business can transferred to a company). A company can relatively easily issue new shares and can even issue shares with different rights attached and for different prices.

Certain tax efficient investment schemes require the business to operate through a limited company.

Limited company key disadvantages
Compliance

One of the prices of limited liability is the compliance regime. Not only do directors have somewhat onerous obligations under Company Law, but the company must also prepare annual accounts in accordance with the Companies Acts and accounting standards. The accounts must be submitted to the Companies Registration Office. Not only is this an additional expense, but any information submitted is available to the public.

Small companies can avail of certain exemptions most notably exemption from audit.

Sole-trader advantages
Simple to set up

There is little or no set-up required to commence as a sole-trade. If you wish to trade using a name other than your personal name you must register a business name with the Companies Registration Office, but that is relatively straightforward compared to setting up a limited company.

No additional compliance

A sole-trade does not file any documents with the Companies Registration Office. Therefore, less information about the business is in the public domain.

Taxation

How can taxation be an advantage when the marginal rate of income tax is 52% compared to corporation tax of 12.5%? If the business will make losses in the first couple of years then those losses can either reduce other income of the sole-trader in the year they arise or be carried forward to be offset against future profits of the business. The losses would therefore be relieved at a higher rate of tax.

Disadvantages
Unlimited liability

Arguably the biggest drawback of operating as a sole-trader. All debts of the business are the sole-trader’s personal debts. You can’t walk away if the business fails and owes money to creditors.

All profits taxed at income tax rates

All a sole-trader’s profits are taxed at income tax rates (see above). This may be okay if the profits are equal to the drawings being taken from the business. But if the profits are greater you may be losing money in tax that could be reinvested into the business.

Many business people starting in business incorporate a company with little thought. There are many online companies offering company set-up services at low prices which makes the incorporation process very affordable and accessible. However, users of these sites are often not getting appropriate advice as to whether a limited company is suitable for them or of the onerous legal obligations of directors.

Think twice before incorporation – it’s not always the best route to business. Always take specific professional advice.

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