What is a limited company...

Includes information about companies run by spouses or other 'household' partnerships

GLOSSARY – you’ll need to understand these terms…

Limited Company – A separate legal entity created (usually) to trade for a profit. It has its own accounts and pays its own tax on the profit.

Incorporation – The process of creating a limited company.

Limited Liability – The notion that a company is only liable to the extent of its own capital and reserves.

Personal Service Company – HMRC’s general term for a one-person company in certain trades and professions.

Companies House – The official body that registers companies and holds the public elements of its records.

Accounts – A set of financial statements showing, in essence, the profit of the company for the year and the tax thereon; the undistributed post-tax profit brought forward and a snapshot of the company’s position at the end of the year (i.e. bank balances, debtors, creditors, assets and so on).

Abbreviated Accounts – As the name suggests, a short version of the full accounts that small companies may submit to Companies House as the public record.

HMRC (HM Revenue & Customs) – The tax office, to whom full and detailed accounts, tax computations and tax returns must be submitted. Dealings between companies and HMRC are confidential.

Accounting Reference Date (ARD) – The last day of the accounting year.

Shareholder – Someone who has bought shares (i.e. provided capital) in a company with a view to receiving dividends on the investment. Shareholders own the company; they do not run it but they hold The Board to account.

Distribution – Dividends paid to a company’s shareholders out of the company’s post-tax (‘retained’) profit.

Director – One of the people who run (manage) the company and who are legally responsible for it. Directors are employees.

The Board – All of the directors. The Board decides on the proportion of the retained profit to be distributed to shareholders.

Annual Return – A relatively simple statement/declaration of the directors, shareholdings, shareholders and other basic company information to Companies House. Not to be confused with [annual] accounts.

Corporation Tax – The tax paid to HMRC by a company on its own profits.

Extractions – A general term for money taken out of a one- or two-person limited company for those persons’ personal income; it doesn’t have an official meaning.

How does a one-person company work?

The same person is the sole director and the sole shareholder. A director takes a salary as an employee and a shareholder gets dividends out of post-tax profit.

The Board decides on salaries and dividends so, to the fullest extent permitted in law, a one-person business has complete freedom to allocate extractions as he or she sees fit.

The director is also, by definition, the person in the company who actually does the work and generates the income. In that way, it may ‘feel’ like a self-employment (sole trade) and the day-to-day business may be no different, but the worker and the company are financially separate and that’s where the director needs to act accordingly – and where it differs from a sole trade.

For the large majority of such companies, to a greater or lesser extent their accountant acts in loco directoris to ensure the principal legal aspects are handled, allowing the person to get on with their business.

Many companies are formed by spouses or other co-habiting partnerships, because ‘household’ taxes can be minimised through different levels of salary and dividends between them.

The main responsibilities of The Board

1. To keep adequate day-to-day financial records, i.e. bookkeeping (although in reality, this may be no more than a monthly update for one-person companies).

2. To ensure the company remains solvent and there is no risk to customers or creditors (this follows from 1 above).

3. To observe relevant laws such as health and safety and to maintain suitable insurance.

4. To act in the best financial and business interests of the company.

5. To arrange for the preparation of annual accounts and tax computations, and for them to be filed on time.

6. To arrange for the preparation of the Annual Return, and for it to be filed on time.

7. To account for all payroll taxes, National Insurance, Corporation Tax [and VAT, if applicable] and to ensure they are paid on time.

Accountants can potentially handle all of these except for item 3, and most usually handle 5, 6 and 7.

The main responsibilities of the shareholders

There are no real legal responsibilities but clearly in bigger companies they hold The Board to account and have the power to demand the removal of directors or even the whole Board. They may also demand that a company is run in a different way but of course this would require a majority vote. This is obviously irrelevant in a one person or ‘household’ company.

A word about Limited Liability

Whilst a company is technically only liable up to the value of its net assets, this doesn’t protect directors from being pursued for negligent behaviour or actions. Negligence might include failure in respect of responsibility 2 above. Indeed, in a one-person company it is almost bound to be negligence that leads to insolvency. Proper professional insurance and taking financial responsibilities seriously is essential.

Forming a company

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Advantages and Disadvantages

This is too big a subject to go into here and is something for discussion at the free initial consultation, but here are the two factors that end up being the bottom line for most people:

1. It will always cost more in accountancy fees and general administrative costs and time to run a limited company than the equivalent sole trade - although much depends on the arrangements for item 1 under the ‘Board’s responsibilities’ paragraph above.

2. In principle, tax can be saved compared with sole trade or partnership in any business where the profit is over about £7,500 per participator.

On present tax rates the profit point at which 2 comfortably outweighs 1 is around £25,000 per participator.

How do I get the tax advantages?

In a self employment, all profit above about £7,500 is subject to tax at 20% and NI at 9%. This is taxation directly upon the individual, regardless of how much of the profit is taken for personal use.

In a one-person company, the sole director can take a tax-free salary of the same £7,500, which reduces the company’s profit by the same amount and hence gets tax relief.

The sole shareholder can take the remaining profit, after corporation tax, as dividends. Dividends are regarded as ‘tax-paid’ as long as the recipient isn’t a higher-rate tax payer. So if the sum of the [sole shareholder’s] dividends and [the same sole director’s] salary does not exceed about £39,000, there is no personal tax to pay.

Meanwhile the company pays 20% tax on the profit remaining after the salary deduction.

So as you can see, effectively incorporation potentially saves 9% on overall taxation on profit over about £7,500 in a one-person company. It’s the point at which this saving exceeds the additional accountancy and administrative costs that counts.

Although the maths gets a bit more complicated, there can be even bigger tax savings for spouses or (‘household’) partners. This works in two ways:

1. If the ‘other half’ has no other income, that’s another £7,500 that can be earned tax-free.

2. Excess dividends that would otherwise make the recipient a higher-rate tax payer can be paid to the ‘other half’.

Subject to certain conditions, this is all quite legal and savings can easily be in the thousands – but everything must be administered correctly and that is why accountancy and other support costs are higher than for the equivalent sole trade.