When you trade as a sole trader or as part of a partnership, strictly speaking you do not have to prepare or send a copy of your business accounts anywhere! That may surprise some operators who’ve always assumed that they were paying their accountants to do just that, and we’d be the last people to recommend trying to run a business without preparing annual accounts (at the very least). However, the accounts are only used to establish the owner’s income. Obviously if HMRC questions the income that is declared by an individual, it is useful (to say the least) to have a proper set of accounts to support what you’re telling them.
For limited companies, the situation is rather different. Each limited company has what’s called an ’accounting reference date’ more commonly known as a ’year-end’; and the company must prepare financial statements to that date every year. What’s more, these ’statutory accounts’ don’t just have to be sent to HMRC, but need to be filed with Companies House at which point they’re available for anyone to see. These accounts have to conform to certain defined standards and formats which largely depend on the size of the company, but that’s one reason why year-end accounts for limited companies are more expensive to produce there has to be more supporting documentation behind the accounts for a limited company.
Because a limited company is a legal entity in its own right, it is subject to taxation in the form of corporation tax. The amount of tax is based on the profits shown in the company’s annual accounts and essentially has nothing to do with the amounts taken out of the company by the directors (salary, loans) or shareholders (dividends). There are three basic rates of corporation tax, dependent on the taxable profits. For companies with a taxable profit of up to £300,000 the rate is currently 20%; if the profit is between £300,000 and £1.2m the rate is 23.75%; and above that it is 23%. This separate taxation is another reason why the accounting costs for limited companies are usually higher than for sole traders your accountant has to take the figures from the ’statutory accounts’ and transform them into a corporation tax computation that is submitted to HMRC along with the annual accounts.
This is another area of confusion for newcomers to the limited company mode of operating their business.
In simple terms, directors are paid by salary, while shareholders are entitled to dividends. If, as is common with small companies, the directors and shareholders happen to be the same people, then they may have some choice as to which method is most tax-efficient for them personally, but the two methods are entirely distinct from an accounting and tax perspective.
If a director is paid a salary by the company, it is usually the same way as for any other employee ie subject to the director’s personal income tax and National Insurance contributions being deducted from their salary under the PAYE scheme. The ’cost’ to the company of the director’s pay is usually shown separately in the company’s accounts, but to all other extents and purposes is just a ’wage’ or ’salary’ cost like any other.
As we’ve already mentioned, it’s very likely that if you run your business as a limited company then you’ll be both a director and a shareholder.
As a shareholder you may be entitled to dividends from your company, and this method of paying yourself may result in a lower personal income tax liability for yourself than if you received the same gross amount in salary. However, you need to be aware that dividends are not a ’cost’ to the company. They don’t count against the profits subject to corporation tax but are a ’distribution’ of the company’s profit. This is an important distinction but one often misunderstood. Imagine that your company makes a profit of £35,000 in the year before you take your own gross salary into account, and you wish to pay yourself £25,000 gross salary. The company’s Corporation Tax liability will then be based on a taxable profit of (£35,000-£25,000) = £10,000 for the year.
Now take the alternative scenario with the same figures, but you decide that as the only shareholder you’ll ignore the salary and pay yourself a dividend. In this case the company’s corporation tax liability will be based on a profit of £35,000, while your own personal income tax return will include the £25,000 dividend as part of your income.
There are several other factors that you need to bear in mind before deciding on ’dividends’ as a means of paying yourself.
The company has to make a profit before it can distribute that as a dividend. All shareholders are entitled to dividends in proportion to their shareholding, so if you only own 75 shares in your company and someone else owns the other 25, then they’ll be entitled to one third of whatever dividend you pay yourself. And one point that’s very often overlooked is that if you ever need to apply for a mortgage or personal loan many lenders tend to ignore ’dividends’ when it comes to assessing your personal income!
Running a limited company is more involved and formal than operating as a sole trader.
There are a lot of rules and quite a lot more paperwork that has to be prepared and then filed with various statutory bodies usually every year. However, an increasing number of small businesses, particularly in the franchise world, are run very successfully in this way. If you’re new to it, or are about to start, you really should seek advice and help from your accountant to make sure that you’re properly set up and meet all of the legal and accounting requirements right from the start.