Beware Of Starting A Limited Co Without Professional Advice

The “S” in the SME sector usually comprises business owners who are:    

1) Already in business as sole traders or partnerships, or

2) Those who are start ups 

Limited Company Set Up (Incorporation) 

There are advantages and disadvantages of setting up a limited company in order to carry on an existing or proposed trade. It is not the purpose of this post to debate the pros and cons of setting up a limited company. 

The purpose of this post is to encourage people to take professional advice before they set up a limited company as not doing so can ultimately threaten the solvency of the company. 

It does not follow that the option to form a company at Companies House means that all directors / shareholders have the required experience, skills and competence to operate a limited company properly. Many directors / shareholders are very capable, but there are many that are not because they are unaware. Akin to servicing your own car simply because you can open the bonnet and start tinkering with the engine.   

The company formation process at Companies House enables shareholders to form a limited company very quickly and for minimal fees. After the company has been set up Companies House send the director(s) summary brief information about their responsibilities. 

It must be remembered that Companies House are a government agency. They are not professional advisers, nor should people expect them to be. 

Many company founders will obtain advice from their accountants who will set them straight from the outset about how to run a company. However, if professional advice has not been taken the main dangers set out below can arise.

Company Solvency Issues

A company’s solvency is not just dependant on the competence of it core activities. A construction company could be very successful in building projects for its clients, but its solvency could be threatened because the business owners withdrew excess funds for themselves, and/or did not provide for taxes.

At all times the company must be solvent which means that the company’s balance sheet must include all liabilities and still have assets. The technical jargon is that the company should have Net Realisable Reserves after providing for all liabilities and withdrawals by the directors / shareholders. 

These liabilities must include a provision for corporation tax.

Take the following example:

ABC Ltd is 6 months into its trading.

• Profit & loss account shows taxable profits are ￡60,000.
• Balance sheet shows Net Assets of ￡5,000

At first glance this might seem OK.

However, if the balance sheet at the end of the 6 months trading does not include a provision for corporation tax, then the accounts will need to be adjust by the amount of corporation tax (assumed 20% rate)  

P & L Account

• Profit before tax ￡60,000   
• Minus Tax 20%  ￡12,000
• Net Profit          ￡48,000

Balance Sheet

• Net Assets         ￡5,000
• Minus Tax       (￡12,000)
• Net Liabilities (￡ 7,000)                     

So after providing for corporation tax, what was previously thought of as a net asset position, is infact a net liability position. Very different.

After 12 months trading the position could be much worse. In fact if the director waits until 8 or 9 months after the year end (ie almost at the end of the second year of trading) to get the full accounts done, the position could in real time be very much worse.    

Excessive Directors / Shareholders “Drawings”

Funds drawn out be directors / shareholders need to be “covered” by a combination of salary (which is subject to PAYE) and / or dividends.

If the net salary and dividend voted to a director / shareholder amounted to say - ￡40,000 but the funds drawn actually drawn out by the director / shareholder amounted to say - ￡70,000, then there are “excess” drawings of ￡30,000.

This means the director / shareholder owes his own company ￡30,000. This is referred to as an “overdrawn director’s loan account”  

Additional Corporation Tax (Under S455 Corporation Taxes Act)

There is also a tax consequence when a director / shareholder has an overdrawn director's loan account. 

In addition to “normal corporation tax” on company profits, the company also has to pay “S455 corporation tax” on the loan owing from the director at the rate of 32.5%.

So if ￡30,000 is owed to the company by the director the additional S455 liability is ￡9,750 – ie ￡30,000 x 32.5%.  

If the director / shareholder had not taken advice then the S455 liability above in the sum of ￡9,750 would come as a nasty surprise. S455 can often double, or more than double the "normal" corporation tax bill.

Possibility Of Winding Up Petition Being Issued

If the company cannot pay the ￡9,750, it runs the risk that HMRC will issue a Winding Up Petition. If that happens then the company's liquidator, be it the Official Receiver or Insolvency Practitioner will demand from the director the full ￡30,000 that he / she owes to the company.

All in all, a very expensive, stressful and life changing consequence, of failure to take professional advice at the time of incorporation. This is increasingly important with the advent of Making Tax Digital and its roll out by HMRC over the next few years.

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