One of the most important considerations that business taxpayers are likely to face is the question of whether or not they should operate their business as a sole trader/partnership or through a limited company. This could be on start-up of the business or once an unincorporated business has been trading for a few years and has become established.
One of the main tax disadvantages of a sole trader/partnership is that the proprietors are taxed on the total of their business profits irrespective of how much is actually withdrawn from the business. Having to pay income tax and national insurance on relatively healthy profits can put an enormous strain on cash flow where that business is attempting to expand.
Some of the key benefits of incorporation are:
- personal tax is only payable on profits actually extracted from the company via salary and dividends ~ compare this with a sole trader where the proprietor is taxed on the total profits arising
- option to withdraw a ‘low‘ salary up to £8,060 pa (for the 2015/16 tax year) from the company to avoid any national insurance liabilities. This salary is of course tax deductible against the company’s profits
- corporation tax payable at only 20% on company taxable profits
- tax efficient low income tax rates on dividends extracted from the company
- limited liability ~ subject to personal guarantees
- flexibility over timing of income extracted from the company
- business premises can remain in personal ownership
- funds accumulated within the company can be extracted on a sale of the shares via a capital gain qualifying for Entrepreneurs Relief at the 10% special rate of capital gains tax
It should be noted however that from 3 December 2014 where goodwill is ‘sold’ to the company via a loan, the former proprietor will be denied from claiming Entrepreneurs’ Relief (ER). Capital gains tax will be payable immediately on the goodwill gain arising at the normal rates of 18% or 28% rather than 10%.
Indication of potential annual tax savings:
The following example provides an indication of the annual tax savings (to the nearest £100) which are currently achievable for the 2015/16 tax year at various profit levels by a sole trader incorporating a business:
Profits |
Total Tax and National Insurance |
Potential annual tax saving |
|
|
SOLE TRADER |
COMPANY* |
||
|
£25,000 |
£4,600 |
£3,400 |
£1,200 |
|
£50,000 |
£12,800 |
£9,100 |
£3,700 |
|
£100,000 |
£33,800 |
£29,100 |
£4,700 |
|
£150,000 |
£58,000 |
£53,000 |
£6,000 |
*Assuming sole director/shareholder is paid a salary of £8,060 pa and that all of the remaining post-tax profits are extracted as dividends.
Utilising the Employment Allowance
Whereas a salary figure above £8,060 will give rise to Employee Class 1 NIC it should be noted that the first £2,000 per company of EMPLOYER Class 1 NIC liability is now exempt under the Employment Allowance.
So for example, where a salary of £10,600 is paid, equal to the 2015-16 tax free personal allowance, and provided dividends withdrawn are contained within the director’s basic rate band, then an overall tax saving of £203 pa can be achieved. The net saving takes into account the additional corporation tax relief on the higher salary.
Where the Employment Allowance is not available against a particular salary then the overall tax and NIC figures, across all profit levels, actually increase where a £10,600 salary is taken rather than £8,060.
However in order to use the Employment Allowance in the most effective way, salary levels must be tailored to each situation by taking into account other factors such as:
any investment and rental income of a director, the income position of co-directors and the number of and salary levels of other company employees.
The Employment Allowance can also be used against any Employer Class 1 NIC liability of staff employed by a sole trader or partnership but note that it is NOT available to set against any Class 4 or Class 2 NIC levied on self-employed profits.
Full details of the Employment Allowance can be found at the following link:
http://www.marshvision.com/NIC-Employment-Allowance.asp
Greater tax savings
Even further tax savings are of course possible where some of the post-tax profits are retained within the company or where a husband and wife are both directors and shareholders. For example, where £100,000 annual profits are currently shared equally within a husband and wife partnership, the overall tax saving potentially increases to around £7,400 per annum by using a limited company structure.
Avoiding penal marginal rates by using a limited company
The potential for director/shareholders to have flexibility over the amount and timing of salaries and dividends extracted from their company can also be very tax efficient in terms of:
- Reducing total income below £60,000 thereby minimising the High Income Child Benefit charge.
- Reducing total income between £100,000 and £121,200 thereby minimising the amount of lost personal allowance.
- Reducing total income to below £150,000 thereby eliminating the special higher rate applicable to dividends of 37.5% (or 45% for salaries).
