It’s something of a common practice for people to start off in business as a sole trader. It’s relatively easy to set up as there are fewer regulations and little cost, and I would recommend it as a structure to start in business. There are some businesses where people will have to start out as a limited company, but that depends on their exposure to liability. If you were to open a restaurant, for example, you would have a lease, employees, and customers from day one. In this situation, it would be suitable to start off as a limited company. It’s not unusual for a new business to make a loss in Year 1, break even in Year 2 and then finally make a profit in Year 3. The question people often ask is how long do you stay as a sole trader and when is the right time to become a limited company?
In Ireland particularly, personal income tax is high (up to 56% depending on how much you’re earning). Corporation tax on the other hand is reasonably low, at 12.5%, and this makes a real difference. Once you’re making over €60,000-€80,000 a year and certainly if you’re making over €100,000 in profits, that’s the trigger point where it makes sense to become a limited company. On average, it costs around €1,500 more per year to run a limited company. There are increased accounting fees, returns and payroll costs, plus it costs around €300 to set the company up.
However, the savings will be made once your business reaches a certain size. There are a few areas where limited companies can save money, whereas if you’re a sole trader all the profits of the business are taxed at income taxed rates. If those profits are high, you could be looking at 40% income tax, 4% PRSI, 7%-8% USC… it all adds up. With a company, it’s 12.5% of the profits no matter how high the rates are. As an owner of a company, you’re entitled to pay yourself a salary and giving yourself a modest salary of €35,000 a year will result in you paying low tax rates.
The benefits of being an employee
As an employee of your limited company, you can claim expenses – which is something you cannot do as a sole trader. Claiming mileage expenses can be one advantage, especially when using your personal vehicle for business. You’re entitled to claim mileage at civil service rates, and these rates are very generous at up to 60 cents per kilometre. This means you could be claiming anything from €300-€500 a month tax-free from your business. The same applies to travel costs, lunch allowances and overnight allowances.
Another advantage is being able to make greater pension deductions. This allows you to transfer money into your pension through the company. There are a whole variety of extra costs that you can put through a limited company. That alone will outweigh the actual extra costs involved in running a limited company and this will prove to benefit you in the long run as your business grows. At this stage, you will have employees, a lease for your premises, contract jobs from third parties and you might also want investors to invest in your business. This is difficult to do when you’re a sole trader, as you can’t give out shares on a business that is personally guaranteed.
With a limited company, you can issue shares. Your company is a separate entity to you; therefore you’re not personally guaranteeing anything unless you personally agree to finance something. From our experience, most businesses start off as sole traders and then advance into a limited company after two years or so. The reason for this is usually tax-driven and happens when profits have reached the stage at which it’s no longer tax-efficient to remain a sole trader.
An alternative to limited companies is partnerships. Partnerships are like a sole trader structure, but with more than one person involved this can at times prove problematic. With a partnership, there’s always the risk of your partner creating liability. Your partner may have borrowed money and lost it all, creating a sizeable amount of debt. As the partner, you are liable for their debt in full, whereas with a limited company your liability is limited. When I talk to clients, I generally suggest that they only go into partnerships with family members or people that they have a lot of background with. It doesn’t always work when partnering with friends, and if doing so, it’s essential that you have a partnership agreement. This is important when discussing how you’re going to share the money, amongst other various factors that come into play in a partnership.
So, starting as a sole trader is fitting, especially in the first year or two while profits are lower and you’re not paying much personal tax either. Progressing to a limited company after a few years, when the business is bigger and more profitable, tends to make a lot of sense. And if you’re contemplating a partnership, consider the risks carefully and make sure that you’re in business with a suitable partner.