It is natural for friends and family to want the best for you, and quite often they take the opportunity to give advice based on their own circumstances. Once upon a time incorporation was, more often than not, the sensible option for a business once it’s profits reached a certain level. However, in recent years changes to tax legislation means that many of the tax breaks no longer exist. Are there any remaining related tax benefits?
Sole Trader versus Limited Company
Limited companies are taxed on profits at a flat rate of 19%, compared to sole traders that are taxed at 20%, 40% or 45%, depending on the level of profit generated.
As a sole trader, your business profits are wholly linked to you as the business owner. Therefore, you can draw the money (providing it is available in the bank), at any time, as the funds have, for all extents and purposes, been taxed.
If your business trades as a limited company, you become an employee. Whilst you may be responsible for everything to do with the company, your tax status is wholly separate.
Even though the company generates business profits, as a limited company director, you still need to draw money from the company as remuneration, which, unlike a sole trader, needs to be taxed.
There are two ways to draw money from a company; salary and dividends.
Before April 2016, the big advantage of trading as a limited company was the dividend tax structure, which allowed dividends to be paid to a director, up to a certain level, with zero tax implication.
In summary, this meant the company paid tax at 20% and the director paid tax as low as 0%.
What has changed?
The most recent change affecting the decision to incorporate, links to the dividend tax restructure in April 2016.
The tax rate within each tax bracket has increased by 7.5%, and whilst there is now a £5,000 tax-free dividend allowance each year, most directors that were enjoying tax-efficient dividends, will now be paying more.
Using a typical scenario of a basic salary, topped up with dividends to the top of the basic-rate threshold, directors will be paying approximately £2,000 a year more.
Those directors that draw dividends, in excess of the basic rate tax threshold, will pay much more.
Unfortunately, this change has wiped out much of the tax benefits of incorporation, particularly for small to medium sized businesses.
Are there any remaining benefits of incorporation?
Whilst the tax bill for directors’ has increased, it isn’t likely to exceed the tax paid by a sole trader.
Also, drawing dividends is still more beneficial than drawing a salary, where National Insurance applies.
However, the cost to manage a limited company is more, with higher accountancy fees to cover the additional compliance required.
Aside from financial reasons, being a limited company can offer a more secure trading structure for you personally.
As you are “just an employee”, it means your responsibility is limited. This means that your personal assets are somewhat protected should your business fail. If your company needs to borrow money from the bank though, they may still require a personal guarantor.
Limited companies also tend to hold more esteem with other businesses, as a successful entity, so this can be an advantage when dealing with customers and suppliers.
Tax planning is a complex area and there isn’t a “one size fits all” model. It is always best to speak to an accountant about your specific situation.
It is a case of calculating the estimated tax as a sole trader and that of a company and making an educated decision linked to your long-term objectives.
AJN Accountants are specialists in helping contractors, freelancers and small businesses to save tax and time.
Please contact us for more information:
T: 020 3866 8951
Follow AJN Accountants on Twitter for regular updates.