Sole Trader or Limited Company – Which is more Tax-Efficient?

By: Patrick
25 Nov, 2022

One of the primary questions when starting a business is which legal structure will suit my business the best? When starting a business, it is not only important to consider the prospects for revenue but also the costs. The tax on profits is one such cost that is affected by the nature of the entity’s legal structure.

Business owners need to determine whether to opt for Sole Trader or Limited Company when starting their business. We understand that it can a difficult to understand the pros and cons of each option. This guide explains the difference between the two options and also makes you aware of the tax implications for each. This guide will also help Sole Traders to understand the consequences of changing to a Limited Company.

 

How are Sole Trader and Limited Company structures different?

Being a Sole Trader, the business and its self-employed owner are treated as a single legal entity. This means that where the business starts to have problems, the personal assets of the owner could be at risk in order to settle the liabilities of the business.

In contrast to this, a Limited Company is a separate legal entity and the owners or shareholders are responsible for the business debts or liabilities only to the extent of their share in the business.

 

Which legal structure suits my business more?

The legal structure that is best for your business largely depends on your circumstances. Sole trader business is fairly simple to setup and many business owners prefer to enjoy the flexibility and freedom that it offers. However, it has its own disadvantages of not having easy access to obtaining business finances, attracting customers or claiming tax reliefs.

On the other hand, setting up a Limited Company can be more complicated, requiring more documentation and costs to be set up, but opens your business up for certain advantages when it comes to obtaining business loans, customer confidence or being tax-efficient.

Now let’s have a look at the specifics relevant to tax liability….

 

Do I pay less tax as a Sole Trader or a Limited Company?

When it comes to the tax liability of a Sole Trader and Limited Company, there is a significant difference in the rates of taxes applicable to the profits from the business.

When you are a Sole Trader, your earnings are subject to a tax rate of up to 52%. In comparison to this, a Limited Company pays tax at a rate as low as 12.5% on its profits.

While a Sole Trader pays tax essentially on everything earned during the year, being a director of a Limited Company provides greater flexibility on how and when you pay yourself and also enables you to structure your earnings in a more tax-efficient way.

 

Example calculation for showing the tax liability for a Sole Trader vs. Director / Owner of a Limited Company

The below mentioned example is to demonstrate how being a Sole Trader or a Director of your company can impact your tax payments. It is important to note that this is only a sample calculation and is based on generalised assumptions, therefore it is advisable to discuss your circumstances with your accountant, to get a more realistic view of your expected tax bill.

Sole Trader Limited Cpompany
Turnover (A) €80,000 €80,000
Gross Salary (B) €25,000
Business expenses (rent, utilities, travel) (C) €15,000 €15,000
Taxable Profit (A-B-C) €65,000 €40,000
Corporation Tax @ 12.5% €5,000
Personal Tax €19,222 €2,822
Total Tax Amount €19,222 €7,822
Total take home income €45,778 €57,178

Notes:

  • Personal tax includes the impact of income tax on salary, tax credit, PRSI and Universal Social Charge.
  • The Sole Trader earns the net drawings (taxable profit minus personal tax) – €45,778 while the director takes home the sum of net salary (Gross salary minus personal tax) – €22,178 and the dividends out of the Profit for the Limited Company (taxable profit minus corporation tax) – €35,000.
  • It is important to note that the dividends paid to the director are also subject to tax deduction.

 

How to plan director’s or employee’s salary and expenses in the most tax-efficient way?

A company has more flexibility to work around the different payments going out to the directors or employees (as illustrated above) and therefore can reduce their overall tax liability. These payments could include salary, dividends, loans or expenses.

Let’s look at each of these in more detail:

  • Salary – A monthly or weekly salary going out to directors or employees can be determined by the company at an amount that falls in the lowest tax rate band. These salary payments are deducted as expenses from the company’s turnover and will reduce the profits and consequently the corporation tax;
  • Dividend – Where a director is also a shareholder of the company, he / she can get dividend payments on regular intervals during the year. It is important to note that director has to pay the tax on the dividend payments received by him based on the income tax rates applicable to his personal income.
  • Director’s fee / expenses – There are certain expenses which, if the employees or directors incur them in the performance of their duties, are tax deductible. Examples of such expenses include subsistence or travel expenses on a business journey or reimbursement to employees when they use their own car, motorcycle or bicycle for business purposes. These expenses are allowed to be deducted from company’s turnover and therefore reduce the tax liability by reducing the company’s profit.
  • Pension contributions – Not only do these contributions provide a post-retirement benefit for the employees or directors, but can serve as a tool for efficient tax planning for the company. The contributions could be made to a small self-administered pension or an executive pension plan and they are tax allowable, resulting in a reduced corporation tax bill for the company.

 

Further questions? We can help….

Depending on your circumstances and the growth prospects of your business, it is always beneficial to get professional advice about which form of legal entity will suit your particular situation. Our support agents are available to help you understand your options and advice you in your best interest.

Are you starting off to set up your business and looking for answers to efficient tax planning? Or are you a Sole Trader who is considering to change to a limited company, for any specific queries relevant to your circumstances, give us a call on +353 1 401 3286.

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