A Guide to Limited Companies
We hope our Guide to Limited Companies will assist you - click on a link to read more information on that subject:
- Overview: The Company, its Shareholders and Directors
- Regulation and Reporting
- Some Advantages
- A Tax Advantage?
- The Drawbacks
- Taxation of the Directors
- Selling up or Dissolution
- And Finally
- Disclaimer
1. Overview: The Company, its Shareholders and Directors
A limited company is a separate legal entity altogether from its owners. Anyone wishing to carry on their trade through the medium of a private limited company will find that they wear two ‘hats’: they will be both a shareholder and a director of the Company.
The shareholders own the Company; the Directors are responsible to the shareholders for its stewardship.
Commonly the directors and the shareholders are the same individuals but nevertheless they have two different legal identities each with their own rights and obligations – the two different ‘hats’ referred to previously.
The Company carries on the business. It is worth remembering that the terms ‘company’ and ‘business’ are not interchangeable. A self-employed man carries on a business. He may even use a trading name, for example D Ferential trading as D F Motors, but it is not a company. On the other hand a company may carry on the business of D F Motors. Like a self-employed man it may use a trading name, but it must also disclose its true identity in its dealings. What is essential to understand is that it is the Company that is carrying on the business. The directors do not stand in the same position with regard to the business as does a self-employed man – the business of a self-employed man is his own.
It is normal for shareholders to have a shareholders agreement, a little like a partnership agreement, which sets out the duties and responsibilities of each director/shareholder, their salaries and other matters such as the rights of continuing shareholders to have first refusal on the shares of a retiring shareholder and so on. Such agreements can be very useful in minimising the prospects for dispute between the shareholder/directors.
2. Regulation and Reporting
A substantial body of legislation contained in the Companies Acts governs the Company. It must submit accounts to the Registrar of Companies each year, which are then available for public inspection (although an additional set of abbreviated accounts can be prepared and submitted which limits the information disclosed).
The accounts have to be prepared in a particular format set down by the regulations. There are penalties for late submission and a failure to submit on time can give rise to a criminal prosecution. And some Directors have indeed been prosecuted even though the accounts were eventually submitted.
An Annual Return also has to be prepared and submitted to the Registrar.
The Company must, in addition to its books of account, maintain Statutory Registers which record the names and addresses of the officers of the Company, shareholders and so on and which are available for public inspection. Similar information is also held for public inspection at the Registrar of Companies. The rationale is that if the owners of a business are to be given the protection of limited liability then the public is entitled to know who they are and the state of affairs of the Company in order that its creditworthiness may be better judged.
3. Some Advantages
The term limited, as in limited company, actually refers to the limited liability of the shareholders. Thus if a shareholder subscribes to the Company for 100 £1 shares his liability to the creditors of the Company, should it fail, is the loss of his £100 shareholding since only the Company is ordinarily liable for any debts that it may incur. It therefore brings a certain degree of protection to its owners if things go wrong.
However, in practice it is by virtue of being a director rather than a shareholder that the owner can be liable for the Company’s debts. Typically, if borrowings are required the bank will require a personal guarantee by the director and, should the Company founder then the liquidator, appointed by the creditors, can examine the role of the director and, broadly, if he can establish that the director did not discharge his responsibilities to the Company properly, if for example he were reckless or stripped the Company of funds to the detriment of its creditors, then he can be held personally liable.
Thus trading through the medium of a private limited company while providing a measure of protection to its owners certainly does not provide complete protection. The director has a responsibility to the Company, to its shareholders, employees and suppliers and, increasingly, to the wider world.
It can be easier to raise loan finance with a limited company. In particular banks may take out what is known as a ‘floating charge’ by way of security on the whole assets of the company, including sums owed to it by its customers and on its stocks and equipment and so on. And if a ‘business angel’ is sought to provide finance (and often expertise), then shares can be readily issued in exchange for an injection of permanent capital into the business.
4. A Tax Advantage?
The Company is subject to Corporation Tax, not Income Tax. Its profits are calculated in much the same way as those of a self-employed man (see Self-Employment Guide), but with one very significant difference – the pay of the director is normally a deductible expense from the Company’s profits, quite unlike the private drawings of a self-employed man, which are not deductible from his profits for income tax purposes.
A company can have a taxation advantage in certain circumstances. Perhaps most importantly for small businesses, the Smaller Companies Corporation Tax rate, being more or less equivalent to the basic rate of Income Tax, enables higher rate tax liability to be avoided, or at least deferred, to the extent that profits are retained in the Company.
Companies may therefore be useful where either the nature of the business is likely to be of particularly high risk e.g. road transport, main contracting etc., or where substantial profits are expected to be made (which would give rise to higher rate tax liability) and there is a need to retain funds within the business, for example either to provide working capital to expand the business or to fund the acquisition of expensive assets such as property or plant. Thus if the whole of the profits of an enterprise are required by the owners for private purposes, then the limited company device will not normally be of any use in the reduction of tax liabilities; on occasion quite the opposite.
The Company receives a Tax Return of its own. Ordinarily the directors will be issued with personal Tax Returns.
5. The Drawbacks
However, there being no such thing as a free lunch, they come complete with a host of drawbacks which make them undesirable for small businesses unless there are very good reasons to have them.
Most importantly, and a point commonly misunderstood even by those who have them, is that the profits (and assets) are the property of the Company and do not belong to the shareholders (owners), and indeed, if the property or the funds of the Company are unlawfully diverted to the shareholders then they may be prosecuted for theft and the proceeds confiscated under the Proceeds of Crime Act (it has happened), quite apart from some very unpleasant tax consequences.
It is a common error to think that a limited company can be established and the owners can then carry on in the relatively free-and-easy fashion they did when they were self-employed, taking out just what they thought fit when they felt like it with no tax consequences. It is a much more onerous regime altogether.
As a result, in our experience, it costs substantially more to attend to the affairs of a small businessman who chooses to trade through the medium of a private limited company than of one who trades in a self-employment capacity.
6. Taxation of the Directors
The owner, in his capacity as a director, is an employee of the Company and must have PAYE operated on his remuneration; quite unlike a self-employed individual who is under no such obligation.
Other than through the payroll the owner can only be remunerated directly through dividends declared on shares. Any benefits-in-kind which he receives, such as a company car, payment by the company of his home telephone bill and so on have to be returned to the Revenue through a P11D Benefits-in-Kind Return and will be taxed on him accordingly.
Employers’ and Employees’ NI have to be paid on the director’s remuneration and together these will commonly exceed 20%. It can be a substantial additional burden when compared with the NI contributions of a self-employed man if particular care is not taken.
The profits of the Company after the deduction of the director’s salary may be distributed by the Company or not as it thinks fit. If it is decided that after-tax profits are to be distributed then a dividend will be declared. The directors may choose to pay interim dividends to the shareholders and the shareholders must ratify the final dividends.
Normally the dividend is for a stated sum per share and each shareholder receives a dividend appropriate to his shareholding. If the shareholder is a basic rate taxpayer, then there is no further tax to pay, but if a higher rate taxpayer then there is an additional tax liability payable through their Self-Assessment Tax Return to reflect the higher rate charge.
Often a director/shareholder will benefit from a combination of salary and dividends. The latter may be attacked by the Revenue as disguised pay if the formalities are not observed. For certain ‘personal service’ companies there is a whole raft of anti-avoidance measures, commonly known as IR35, designed to counter the perceived loss of tax arising from such arrangements.
If it is intended that a spouse be involved then the Income Shifting rules proposed by the 2007 Pre-Budget Statement are likely to give rise to yet more problems, but that will apply equally to partnerships.
As a matter of general law directors may not borrow from the Company, although they may lend to it. The Company can pay interest on loans received from directors and may receive a tax deduction for it. However the interest is then taxable in the hands of the director. If the director’s loan account becomes overdrawn then the director is treated as having received a distribution of taxed profits and the Company is liable to pay a sum to the Revenue calculated to be the equivalent additional tax which would be payable were the director subject to higher rate tax liability (whether he were or not). An interest charge will also arise on the benefit of the loan received by the director and the director will be taxable on that.
Directors bonuses are not, as is sometimes thought, tax-free, but rather they are simply remuneration and are subject to Income Tax and NI in the normal way. Bonuses are commonly calculated and paid following the Company’s accounting year-end. They are normally a deductible expense for the accounting year to which they relate but they must be an established liability at the year-end and be paid within nine months of the accounting year-end for that relief to be obtained.
The Company can make personal pension contributions on behalf of the director and a tax deduction will be permitted so long as the contribution is made within the rules, which, broadly, require that they be made for the purposes of the trade. Difficulties can arise if the Revenue decide that the amount of pension contribution made is inappropriate having regard to the actual duties and responsibilities of the director concerned. Similar problems can arise if family members are on the payroll.
7. Selling up or Dissolution
The Company has no pre-determined lifespan. Since it has a legal existence separate from its owners it can be a convenient vehicle in a family business involving one generation succeeding another.
It can be wound up either by the members voluntarily or by its creditors in an insolvency.
If the owners wish to sell up they may either sell their shares in the Company or the Company may sell its assets and business and then distribute the proceeds to the shareholders; thereafter the Company can be wound up and struck from the register. Each has very different tax consequences and considerations.
8. And Finally
All of the above obligations come complete with tight deadlines for submission and severe penalties for failure to do so.
Owning and running limited companies will inevitably involve the owners in a greater compliance burden than self-employment and there are numerous issues and pitfalls to beware. Nevertheless they may well be the appropriate vehicle in the right circumstances and so long as professional assistance is engaged from the outset and the proprietors are prepared to co-operate then no concerns need arise.
We are happy to advise upon the desirability of setting up a company and its structure, arrange the purchase and attend to its initial compliance; thereafter maintaining its affairs in good order.
9. Disclaimer
While we hope you have found it helpful, the above is no more than a brief guide to help the layman understand the distinction between self-employment and limited companies and to give at least an awareness of some of the matters to be understood and considered in choosing whether to purchase a limited company at the outset of trading or to incorporate an existing self-employment into a limited company. It is not a substitute for professional advice and we can accept no responsibility for loss occasioned to any person acting or refraining from acting as a result of material contained in it.