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Should a Sole Trader incorporate?

Limited Liability

An advantage of trading through a Company rather than as a Sole Trader is Limited Liability.  This simply means that debts owed by the company are limited to the company and are not the personal responsibility of the directors.  However, most banks today will look for a personal guarantee, from the Directors, when granting a loan to a company.

Tax rates

A company has a corporation tax rate of 12.5%.  This compares with the higher rate of income tax at 42% and PRSI at 6%.  As directors of the company you will suffer Income Tax on any salary that you receive from the Company.  You will have the advantage of being able to pay yourself salary at any time and not necessarily in the year that the income is earned by the company, allowing scope for tax planning.   Sole Traders are subject to Income Tax, on the full amount of their profit, in the year that the profit was earned.
 
Extracting Profit from a Company

This is one of the main drawbacks of having a business carried on by a company.  Care has to be taken to avoid a double charge to tax.  A company pays tax on its profits, its shareholders pay income tax on any dividend received, its Directors pays income tax and PRSI at an effective rate of 48%, although the salary can be used as a deduction against the profit of the company.   Thus it is generally advisable for a Plumber, for example, earning profits of €40,000, who draws this €40,000 during the year, to remain unincorporated, whilst if the plumber earned profits of €80,000, and withdrew €40,000, he would then be in a position whereby he would still only pay income tax and relevant PRSI on €40,000, but could retain the extra €40,000 in the company which would only have a Corporation Tax rate of 12.5%.  This leads to the problem of extracting these fund in a tax efficient way.  There are essentially four ways of extracting funds from a company:

- Salary  
At discussed above PAYE/PRSI must be deducted at source, the company will receive a deduction from company profits.

- Dividends
The company’s profits can also be distributed by paying dividends.  Dividend Withholding Tax has to be deduced at source and the dividend paid net.  The Shareholder is then liable to tax under Schedule F on the gross amount of the dividend, but is able to receive a credit for the Dividend Withholding tax.  The disadvantage of Dividends is that a Dividend is not allowable as a tax deduction for the company.  The advantage of a dividend is the avoidance of a close company surcharge.  Undistributed income of a service company is liable to a 15 per cent surcharge.  This surcharge, if paid, cannot even be credited against the tax liability.  

- Loans
If a director takes a loan from a company the Director will be liable to tax under Schedule E on the deemed benefit i.e. loan x 11%, assuming that the loan is interest free.  A loan will have to be repaid at some stage.  Care also needs to be taken to ensure that this transaction does not breach company law.  The company must also remit Income Tax on the loan at a rate of 20/80.  This will be refunded when the loan is repaid.

- Pensions
Recent amendments to tax legislation regarding the options on retirement, render pension funds a very tax efficient method of extracting funds from a company.  The Company as the employer may set up a Revenue Approved Pension Fund, for the Directors and Employees, and make contributions to the Fund on their behalf.  Such contributions are tax deductible to the company and are not taxable in the Directors or Employees’ hands within certain limits.  These limits are much more generous than in the case of personal pension plans.

- Employment of Spouses
If circumstances dictate is may be an advantage for the Directors that their spouses work for the company and receive a remuneration package.  This would be important from a tax efficiency viewpoint to ensure that each spouse is utilising their tax band in full and which, along with contributions to the pension scheme on their behalf, would serve to reduce the overall tax bill.

Compliance Costs

Compliance costs are a major disadvantage for a Company.  In addition to the various tax returns a company must also file and return annually to the Company’s Registration Office.  Late filing can result in fines and an additional requirement of an audit for smaller companies.  The Company’s Registration Office are currently engaging in a vigorous campaign of company strike-offs to address the non-filing of returns. From September 1998 to end of January 2003, 67,000 companies were struck off. The consequences of strike off are very serious for a company that is still trading, in that the assets of the company become the property of the State, the Directors become responsible for the liabilities of the company, the company ceases to exist as a legal entity and the protection of limited liability is lost to the company.  Directors may have a disqualification order made against them on application by the Director of Corporate Enforcement and Banks are unwilling to lead money to an entity which has, effectively, ceased to exist.  While it is possible in most instances to have a company restored to the register, this can be an expensive procedure.
Small companies need only file an abridged balance sheet, but still suffer the disadvantage of loss of confidentially, as company accounts filed with the Companies Office can be inspected by anyone.  There is also the time and cost of taking minutes of directors meetings and additional secretarial duties. The obligation to file accounts can be avoided if the company has unlimited liability.

Louise Carey is a Tax Consultant and Accountant with an Office at 21 Church Street, Listowel, Co Kerry.  She may be contact on 068 21109, email: lc@taxconsultant.ie, website: www.taxconsultant.ie.