If you are a sole trader or partnership you may be thinking about setting up a company for your business. Incorporating a company for your business has its benefits and it is not expensive to form a company, however there are many other issues to take into consideration when deciding whether to incorporate.
Advantages of incorporation:
12.50% corporate tax rate on company trading profits
Companies pay 12.50% tax on their trading profits held in the company. Sole traders and unlimited partnerships pay income tax, PRSI and USC of up to 52% on their profits. When profits of a company are extracted in the form of salary, bonus, distribution or dividend, these are taxed at a rate of up to 52% in the hands of the individual. Therefore if all the profits are taken out you do not benefit from the 12.50% corporation tax rate. Consider if your business has sufficient profits which can be left in the company and taxed at the lower corporate rate of 12.50%.
Limited liability protection
A company is a separate legal entity to its owner, directors and shareholders. Creditors can sue the company but not the individuals which own and manage the company. Any claims against the company are limited to the director/shareholder contributions to the share capital held in the company. Although it should be noted that any unlawful behaviour in the trading activities of the business, can result in the protection of the corporate veil being lifted and the directors/shareholders being potentially held liable.
Certainty and Security
A company can continue trading without reliance on any one individual whereas a sole trader generally depends on one person to continue trading. A company has legal responsibilities towards its creditors and cannot easily walk away from these obligations, which ultimately protects suppliers and customers. Banks and investors like to deal with a corporate as they have an added layer of security in the event of a default on their agreement. It is illegal for a company to trade if it is insolvent and cannot cover its debts. Incorporation also demonstrates a certain level of commitment to the permanency of the business.
A company can fund a pension for its employees/directors/shareholders tax efficiently and claim a deduction in its accounts for the expense, subject to limits. Whereas pension contribution limits for sole traders are more restrictive.
Foreign Exchange hedging – Brexit and US
A company can easily set up a presence in another country through a branch or a subsidiary off its main company. Having a physical trading presence in another country is one of the best ways to protect against fluctuations in foreign exchange rates by enabling the company to react quickly to changes and cash pool the foreign currency. In the event of having a downturn in sterling or US dollars, the business then has sufficient currency to trade cross border and also has a domestic presence in those markets from which to manage its trade and currency.
Protects Business Name
The Companies Registration Office will not allow the registration of the same company name twice. When you incorporate a company you are protecting your company name, which can be an asset in itself that you can latter sell on. Some businesses trademark their company name and capitalise it as an intangible brand asset on the balance sheet, this can be franchised or sold on at a later date.
More availability of government grants and investment
Many government grants are only available to companies not sole trades. Banks will lend to companies more easily than private sole traders. Enterprise Ireland and the IDA provide many incentives to assist start up and growing businesses but you are often required to form a company.
Company directors can claim civil service subsistence rates on travel mileage and overnight accommodation in Ireland and abroad, which is tax free.
It is possible to incentivise employees by passing on or selling part of a company to them, using different shares or classes of shares. This cannot be done as a sole trader or partnership. A corporate structure can also facilitate inheritance planning, whereby shares in a company can be passed on tax free.
Corporate restructuring, mergers and acquisitions
Tax reliefs exist for the reorganising, restructuring and mergers of companies into new group structures. Company assets can be hived up or down and then out to new corporate structures with new or existing shareholders. Cross border merger relief allows corporates to takeover other companies in a tax efficient manner. Sole trades generally do not have this agility or access to such tax reliefs.
Groups and corporate structures
Companies can form groups to trade with each other domestically and cross border. Different types of company structures provide specific benefits, such as holding assets, sourcing finance, acting as agents or intermediaries, providing specific benefits to their shareholders.
Disadvantages of incorporation:
Annual cost of maintaining a company
Annual accounts must be prepared for a company and these must be filed with the Companies Registration Office once a year, which increases compliance costs. As the company grows, the accounts may need to be audited, which is again more costly. The accounts of a company filed with CRO are publically available and your business financial information and ownership structure is a matter of public record. This lack of confidentiality is why some large companies remain as a sole trade or unlimited company or partnership.
Increased exposure for the director
Recent changes to the Irish Companies Acts have changed the requirements of Limited companies, it is now possible to have just one company director instead of two, the company secretary cannot be the same person as the director (the shareholders can be the same or different persons to the directors, same as before). The individual company director or company secretary is therefore more exposed and all the legal responsibilities of being a company director rest with one person. Safeguarding the company and shareholder interests, may create a conflict of interests if the director has concerns about their own level of risk exposure.
Close Company Surcharge
Investment and rental companies are generally subject to a surcharge tax of 20% (known as the close company surcharge) on undistributed estate and investment income of the company. In order to avoid or minimise the surcharge, the company has up to 18 months after the accounting period ends to declare and pay a dividend. Other forms of distributions must be made before the accounting period ends to be taken into account as distributions.
A close company providing professional services has a surcharge of 15%, on 50% of the retained professional services trading profits.
These surcharges s are designed to prevent taxpayers from avoiding the payment of tax by arranging for income to be diverted into companies and taxed at a lower rate, which would otherwise be taxed at the higher income tax rates if taken out of the company as a salary, distribution or dividend. The surcharges reduce the differential between corporation tax rates and income tax rates. Sole trades are not subject to these types of surcharges.
Excess cash can be extracted from a company in 3 ways; salary/bonus, dividend/ distribution or liquidation. Salary and dividends are taxed to income tax up to the highest rate; dividends are not subject to USC/PRSI. If cash is left in a company, surcharges may apply. Reinvestment and pension funding are tax efficient ways to avoid taxes on cash extraction. Both capital Gains tax and income tax may arise on the sale of the business. The sale of the shares of the company and the business assets can be subject to capital gains tax. If the shareholder then extracts its remaining funds from the company which is charged to income tax, this exposure to both capital gains tax and income tax creates a double taxation, which does not always arise in a sole trade because there is no share disposal.
A sole trade is restricted from carrying its losses backwards against previous years trading profits, except when it ceases to trade, then it can carry the loss back over the previous 3 years. Losses in a sole trade can be offset against other non-trading income, but company losses can only be used in that trade. Losses in a company can be used in more ways; they can be carried back, forward or sideways in current year. It is very important to note that if you convert your sole trade into a company, you cannot carry the losses from the sole trade into the company, you lose them if they are not used in the sole trade, prior to incorporation.
Incorporation from a sole trade to a company can trigger tax
When transferring assets held by a sole trade or partnership into a company, the transfer of certain chargeable assets from an individual to a company would generally attract CGT on any capital gain. However CGT relief may be given on the transfer of a business to a company, if the business continues to trade and is owned by the same persons. If the relief applies, the company is deemed to acquire business assets at the price which the individual transferring the assets originally acquired them.
It may also be possible to minimise stamp duty on the transfer of business assets to a company by passing assets by delivery as opposed to transferring by deed. The transfer of shares in a company will generally attract stamp duty.
Before incorporating a company, the advantages and disadvantages should be carefully evaluated to ensure that it is cost efficient and meets the needs of your business. As all businesses are unique, a holistic review is required of where the company is at now and its strategic plans for its future. Independent advice should be sought from your accountant on the broad array of issues that can arise from a tax and accounting perspective.