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An accountant’s guide: Transitioning from a sole trader to a limited company

Sole trader versus limited-liability company – we look at when it’s time for a small business owner to consider transitioning, and the pros and cons.

At a glance

Here’s a snapshot of the advice from our interviewees:

  • Taking on bigger contracts, operating in a risky industry or entering into a partnership can be good reasons to transition from sole trader to company.
  • There can be potential tax benefits to being a company – check with your accountant.
  • Be prepared for the extra costs and reporting obligations associated with being a limited-liability company.

Almost three-quarters of New Zealand’s small businesses are sole traders. How long can they continue to operate efficiently and effectively as sole traders? We asked Mike Pirovich, Director of Bare Bones Accounting, to help explain the key differences between sole traders and limited liability companies, and things to consider before making the transition.

What’s the difference between being a sole trader and a limited liability company?

“As a sole trader, you’re trading under your own personal Inland Revenue Department (IRD) number. You declare your income to the IRD and pay tax on that income,” Mike says.

You have to register for GST when your income reaches $60,000 per annum and, while you can continue to operate as a sole trader if you wish, it’s a good milestone at which to assess whether that’s a suitable structure for your business.

“Trading as a limited-liability company requires you to form a company with the New Zealand Companies Office and get an IRD number for the company – a completely separate entity to the personal IRD number you would hold as a sole trader,” Mike says.

As a limited-liability company, all of a business’s assets, debts, profits and liabilities are listed under a registered company name.

Why might I transition from sole trader to limited-liability company?

There are a few reasons why sole traders decide it’s time to form a company and some associated benefits to consider.

Reduce personal liability

“Being a company gives you some protection from liability. If things go wrong and you’re operating as a sole trader, you’re personally liable for any debts accumulated, explains Mike. That means your personal assets could be at risk.

“And some industries are riskier than others. If you’re a builder, for instance, chances are you’ll want to be operating as a company to mitigate the risks associated with that profession,” says Mike. “But be aware that trading as a company doesn’t absolve you from liability entirely. It doesn’t mean you can trade recklessly or behave negligently, as a director or person conducting a business or undertaking (PCBU).”

If you’re considering going into partnership with someone, then that’s a good time to consider registering as a limited-liability company, says Mike.

“Companies are better for operating a partnership than sole traders because shareholders are not liable for each other’s actions,” he explains.

Increase professionalism

Mike has also seen instances of customers preferring to deal with a company rather than a sole trader.

“They might feel more comfortable dealing with a company and see it as offering more, so taking on big contracts can be a good time to make the transition from sole trader to limited-liability company,” he says. “Operating as a company can be seen to be more professional. It might help potential customers take you more seriously,” says Mike.

Selling the company

Mike has seen sole traders find it more difficult to access finance and loans, particularly if they have fewer or less detailed financial records.

“It depends on what kind of loan you’re after,” says Mike. “It shouldn’t be a problem for, say, a one-off vehicle, but it might be harder for heavy equipment or multiple car leases.”

For sole traders anticipating taking on significant debt to grow their operations, transitioning to a company might be worth considering.

Accessing a loan as a sole trader

In recent research from RFI Global, 60% of  small business owners across New Zealand reported late payments from customers as a top cash flow challenge.* Access to credit can be critical for those businesses’ cash flow management.

Mike has seen sole traders find it more difficult to access finance and loans, particularly if they have fewer or less detailed financial records.

“It depends on what kind of loan you’re after,” says Mike. “It shouldn’t be a problem for, say, a one-off vehicle, but it might be harder for heavy equipment or multiple car leases.”

For sole traders anticipating taking on significant debt to grow their operations, transitioning to a company might be worth considering.

A Prospa Small Business Loan offers quick access to funding between $5,000 and $100,000 for approved applications, including sole traders with 6 months’ trading history who meet eligibility criteria. Find out more and apply now.

Tax benefits of a limited-liability company

Finally, there can be tax benefits associated with forming a limited company, as the company tax rate is 28% whereas the top tax rate in New Zealand is 39% for income over $180,000.

But, while this point gets the lion’s share of attention, it’s a bit overblown – being a company doesn’t automatically mean a better tax outcome.

“Personal income tax is a tiered system,” says Mike, “so for you to be charged tax at the top rates, you have to be making a lot of money. Most small businesses aren’t making that much profit so paying tax on it through personal income tax will often be cheaper than paying company tax at 28% which is a flat rate.

“That’s because the company has to pay another 5% withholding tax when the company profit is transferred to the shareholder’s account through a dividend. This ends up being a flat 33% tax. When company tax-paid profits are transferred as a shareholder’s salary, the income tax is subject to tiered personal income tax rates, which will rarely reach an overall 33% tax rate.”

Sounds complex? Basically, any tax benefits depend on your business’s specific circumstances. So it’s worth speaking with your accountant about if and how structuring a limited-liability company may or may not ultimately deliver tax benefits.

What are the possible disadvantages of operating as a company?

There can be a little more time and effort involved in operating as a company as well as some additional costs – though these aren’t high. You need to register with the Companies Office and get an IRD number for the company along with an NZBN if you don’t already have one.

You’ll also need to set up a bank account for the company and transfer assets into the company name.

And you must produce financial statements that comply with the Companies Act and the IRD’s requirements, including submitting an annual tax return to both the IRD and the Companies Office.

“The standard of reporting does tend to be higher for a company,” says Mike. “Some small business owners try to prepare their own company tax returns. We often get asked to fix things up after a year or two, which can be expensive. I recommend you get your accountant to help you with your accounts and tax, along with any other associated administration. Sometimes it’s better to concentrate on what you’re good at – your business – and let an expert help you with the finances.”

Does being a sole trader or limited-liability company make a difference to pandemic support payments?

Government support, wage subsidies and recovery payments have been largely equally available to small businesses that are either sole traders or companies. One notable exception was the business debt hibernation initiative – now closed – which was available to companies but not to sole traders.

The Small Business Cash Flow Loan Scheme (SBCS) for which applications are open until December 2023, is available to sole traders and limited-liability companies. Eligible businesses – including sole traders – can apply for loans of up to $10,000 plus an additional $1,800 per equivalent full time employee. The loans are interest free if paid back within two years.

If you’re still unsure whether becoming a limited-liability company is right for your business, many accountants will be happy to have an obligation-free discussion with you about what’s involved, and how to weigh up the benefits and obligations associated with transitioning from sole trader to company.

*RFI Global: NZ SME Business Council, November 2021

This article was originally published in 2019 and has been updated for relevancy.

A Prospa Small Business Loan offers quick access to funding between $5,000 and $100,000 for approved applications, including sole traders with 6 months’ trading history who meet eligibility criteria. Find out more and apply now.

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The information on this website is provided for general information only and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from financial, legal and taxation advisors. Although every effort has been made to verify the accuracy of the information as at the date of publication, Prospa, its officers, employees and agents disclaim all liability (except for any liability which by law cannot be excluded), for any error, inaccuracy, or omission from the information for any reason, including due to the passage of time, or any loss or damage suffered by any person directly or indirectly through relying on this information.

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