WITH THE UPTURN in the Irish economy, many small businesses are looking to scale up their operations.
This is a very positive trend; however, it does mean greater tax obligations for businesses. As a business grows, tax takes on increasing importance, both when it comes to ensuring that all tax-compliance obligations are met and for ensuring that the business is using all available tax reliefs.
One of the most important decisions for a business to make is when to incorporate; that is, whether to go from being a sole-trader business to a company.
Why operate a business through a company?
From a purely tax point of view, if the profits of a business are larger than the business owner needs to meet his or her annual financial commitments, then the most tax-efficient option is generally to incorporate the business.
There are numerous advantages to incorporating a business. They include:
Lower tax rates
Ireland’s 12.5% tax rate only applies to the trading profits of companies. By contrast, individuals pay tax on up to 55% of their trading profits.
The business owner can dictate the amount of salary to extract from the company and thus retain a level of control over their ultimate income tax liability by way of PAYE, PRSI and Universal Social Charge.
This is different to the position of a sole trader, who must pay income tax on the total business profits irrespective of whether or not those profits are taken out of the business.
If a business is operated through a company from the start, it may be eligible for a three-year exemption from corporation tax which effectively reduces an annual tax charge of up to €40,000 to nil.
The relief is available whenever a new company is incorporated to undertake a new trade. There are certain limitations on the types of businesses that qualify; for example, service companies are not eligible.
When a business owner decides to incorporate a business and an initial investment is required in the company, it may be more advantageous to make such investment by way of a loan to the company rather than by investing in share capital in the company.
A loan can be repaid to the business owner tax-free by the company as cash becomes available, assuming that business owner becomes a director of the company on incorporation.
With an incorporated company, there is more flexibility regarding the method of remuneration that can be paid to business owners. There are various means of extracting cash from a company such as salary, directors’ fees and dividends.
A company has the ability to pay proper business expenses to employees and directors, such as mileage and subsistence at civil service rates on a tax-free basis, subject to satisfying the relevant conditions.
Pension contributions remain one of the most tax efficient methods of extracting funds from a company, and the company gets a tax deduction for the pension contribution made.
There is more generous tax treatment afforded to company pension plans compared with self-employed pension plans.
Startup refund for entrepreneurs
An entrepreneur may be eligible for a refund of income tax paid over the previous six years based on the cash investment they make in their company.
This refund is not available for a sole trader and only applies to companies incorporated in the past two years, subject to them meeting certain conditions.
Enterprise and investment incentive scheme (EIIS)
This scheme provides income tax relief for entrepreneurs who invest funds in their business in the early stages of trading.
Again, the relief is only available where the business is operated through a company and not as a sole trader. In addition, there are various conditions that must be met in order to qualify for the relief.
In a litigious environment, there are benefits in having limited liability. However, entrepreneurs should be aware that frequently banks and key suppliers may require personal guarantees from the shareholders and/or directors in respect of company debts, thus eroding the benefit of limited liability.
Nevertheless operating through a company can increase the credibility of a business with third parties.
The drawbacks of running a business through a company
These advantages should always be weighed against the disadvantages of trading through a company. These points are worth remembering:
Double charge to tax
Once incorporated, the business is a separate legal entity to the business owner, who is a director and most likely also an employee of the company.
The company pays tax on its profits. In addition, income tax is payable by you (as a company shareholder) on any income or dividend you take from the company.
However the aggregate tax paid by the company and business owner should be less than would be paid where the business is operated as a sole trader, otherwise incorporation would not be advisable from a tax perspective.
When transferring assets to the next generation, tax reliefs can be more complex than those applying to a sole trader. However, such reliefs are not lost with careful planning and management.
Close company surcharge
The vast majority of Irish small companies are subject to the ‘close company rules’ which stipulate that rental and investment income of a close company is liable to a 20% surcharge. Undistributed income of a service company is liable to a 15% surcharge on half of the undistributed trading or professional income.
Stricter expense rules
A company director has fewer expense deductions than a self-employed person.
Additional administration obligations
There will be the annual obligation to file company accounts with the Companies Registration Office, which means a loss of confidentiality as they can be inspected by anyone.
Numerous tax considerations
There are a number of tax issues that need to be considered when incorporating an existing business. If the transfer of a business to a company is not carefully planned, it can trigger expensive tax liabilities – for this reason, getting proper advice before making any decision is essential.
Please note this article is general in nature and does not constitute professional advice.
Mairead Hennessy is the principal at Taxkey.ie.
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