When going into business, an entrepreneur will have to decide what type of business they are going to run; this begs the question what kind of legal structure will the business conduct its activities under? The answer to this directly impacts the structure of the business, the taxes it incurs and the benefits it is entitled to. In Ireland, the choice is between being a sole trader (or being in a partnership) or registering as a limited company.
Incorporating as a sole trader
It is common for a business to start out as a sole trading entity and then to incorporate as a limited company. For an entrepreneur starting out with a new venture, the sole trader option is attractive for the freedom it offers. A sole trader is not subject to charges from the Companies Registration Office or the restrictive measures outlined in the Companies Act. In effect, a sole trading business is a lot easier to set up and easier to shut down. However, the sole trader business does not protect the entrepreneur from risk in the same way a limited company can and, although there are different kinds of charges added to the mix, being a limited company can greatly reduce the amount of tax incurred on profits. Let’s take a closer look at the direct benefits of incorporating a limited company.
Advantages of the limited company
As a sole trader, the entrepreneur is directly responsible for any risks or debts incurred. This is a serious consideration if entering into financial and/or business contracts. In this situation, the entrepreneur is legally inseparable from his/her business. A limited company, on the other hand, means limited liability for such risks. The company is viewed as a separate entity and is accountable separately in such circumstances. Businesses such as restaurants and shops are usually set up as limited companies as they have risks associated with leases, employees and customers.
Lower taxes on profits
Sole traders are taxed at an individual income tax rate and, therefore, incur up to 55% tax (40% PAYE, 4% PRSI, and 11% USC on profits over 100K). Limited companies are subject to corporation tax, which is only 12.5%. This is probably the most attractive reason to incorporate your business. However, it is worth noting that this is only of real benefit if your business profits are not all needed for your own subsistence, because once the profits are taken from the company, they are taxed at income tax rates. Incorporation is better suited to the sole trader business that is already generating profits and cash.
Better reinvestment potential
As outlined above, profits made by a limited company are more valuable for reinvestment purposes. As a sole trader, the hefty tax rate of 55% greatly reduces the potential for significant reinvestment. A limited company that can benefit from investment has a better opportunity to grow.
Higher pension reductions
For the sole trader, pension relief is capped at €115,000 and is simply by reference to their income tax (not applicable to USC or PRSI). However, for a limited company, private pension schemes allow company directors to deduct their pension contributions from company profits before deduction of tax. Furthermore, the employer pension contribution is greatly improved as it is governed by more generous pension funding rules.
It is worth taking into account other people’s expectations of your business when considering incorporation. Many people simply prefer the protection that limited liability provides. Being a limited company can make it easier to secure contracts, particularly when working with non-Irish companies who may expect limited company status.
With regards to mileage allowance, a sole trader can claim back a portion of the costs associated with running a car based on how much of its use is for business purposes and not personal use. On the other hand, a limited company has greater scope when claiming mileage. For employees of a limited company, mileage is calculated by reference to revenue approved civil service rates i.e. cents per mile, which varies by the vehicle type and distance travelled.
It’s important to remember that the 12.5% corporation rate rises to 19.5% if the principal part of the company’s income (> 50%) comes from professional services. Professional services, in this case, refer to services that require a qualification to administer. It is a good idea to closely review what the company considers professional services to be, because in many cases, especially in the case of consulting services, a qualification may not be mandatory.
During the incorporation process, it’s likely that assets will need to be transferred. There are two main options when transferring assets from a sole trader to a limited company:
- sell the assets to the limited company so that the money is owed tax-free to the owner, or
- avail of Incorporation Relief by disposing of the business assets in exchange for an issue of shares in the newly incorporated company.
The latter option is often used when a significant CGT liability occurs, which can happen due to the procurement of taxable goodwill. The benefits of operating as a limited company are wide-ranging and will depend on your specific circumstances. For businesses looking to grow, the additional administration and compliance associated with running a company will typically be outweighed by the gains to be had in switching from sole trader status.