It can make sound economic sense to turn your business into a corporate entity, writes Shane McLoughlin.

Whenever I meet a new client who operates as a sole trader, one of the first questions I ask is: ‘‘Have you considered establishing a company?” The response is invariably: ‘‘Why would I?”

Usually, the rule of thumb is that a business should only be incorporated when it generates more taxable profits than the owner needs to support his or her lifestyle. While this is largely true, it does not give the full picture. So why incorporate?

Lower tax rates and cheaper working capital
One of the major benefits of incorporation is access to the lower tax rates that apply to a company’s profits. The corporation tax rate in Ireland is 12.5 per cent - or 25 per cent for passive income - a significant saving when compared with the maximum tax rate of 46.5 per cent, if you include PRSI and levies.

The lower tax rate is, in practical terms, only relevant when the business is generating more profit than the business owner needs to fund his or her lifestyle. While this may be the case, another benefit arises with regard to working capital.

As a sole trader, an individual is subject to income tax on his taxable profits at his marginal rate of tax. However, as all sole traders know, it is rare that the amount of profits individuals draw down from their business equates with their taxable profits, as calculated for their tax return. This is because a certain amount of profits must be retained in the business as working capital.

As the sole trader will have paid tax on these profits at 46.5 per cent, the actual cost of €1,000 of working capital to a sole trader is €1,870. Because the tax rates that apply to a company are lower, the corresponding cost of €1,000 of working capital in a company is €1,143.

So it makes more sense to build up working capital in a company than as a sole trader, allowing you to increase your investment in the business, if desired, thus enabling the business to grow and, hopefully, prosper.

Retirement planning
Sole traders only have access to personal pension plans. Tax relief on contributions to these plans is limited by reference to the age and earnings of the individual.

Contribution levels range from 20 per cent up to 40 per cent of relevant earnings, with an earnings cap also applicable, standing at €275,239 for the current year.

Sole traders, even where they maximise their pension contributions within the allowable limits every year of their working life, are unlikely ever to get near the current permitted fund limit of €5,418,085.

Company directors, on the other hand, have access to occupational pension schemes, where combined employer and employee tax-free contributions can amount to a significant multiple of an individual’s salary.

Therefore, company directors are in a much better position to achieve a greater level of pension funding, even where they only start to fund a pension in the latter part of their working life. These retirement structures and allowances permit the company owner to retain significantly more of the generated wealth than the same business operating in the sole trader environment.

Indeed, this is borne out by the fact that every pension fund which exceeded the original €5,000,000 cap when it was introduced in 2006 belonged to a company director.

Retirement planning is just one area where profits can be extracted from a company in a more tax-efficient manner than for a sole trader. Other examples of this are beyond the scope of this article.

Succession planning
Generally speaking, a company will be a more attractive business prospect either for a potential purchaser or for transferring ownership of the business to the children.

Not only will stamp duty be reduced with the company structure, but the business owner may also be in a position to extract profits in a tax-efficient manner before the disposal, thus reducing the overall tax cost to the seller and the buyer.

Limited liability
Limited liability with a company will be particularly attractive in certain industries where the risk to the sole trader of losing everything as a result of a claim against the business is substantial.

The limited company structure allows you to limit your financial exposure to the amount of capital you have invested in the business.

Cash extraction
The process of incorporation itself, for an existing business, can be used to allow the sole trader to extract capital value from the business in a tax-efficient manner, as a part of the transfer of the business.

For example, the company can buy the goodwill built up over the years from the sole trader. This allows the business owner to avail of the tax benefits of selling the business - at the 20 per cent Capital Gains Tax rate, rather than at the income tax rate - while retaining control of the business itself.

With careful planning, this can lead to substantial benefits for the business owner. In light of all these benefits, perhaps the question that business owners should be asking is: ‘‘Why am I not incorporated?”

Shane McLoughlin is an associate director of Financial Engineering Network, a financial advisory company. Contact him at shanem@fen.ie