For many years now, it has been taken as a given that it is better from a tax perspective to operate as a limited company rather than as a sole trader.
Hitherto, the tried and tested method of profit extraction was to take a small salary to preserve pension entitlement for zero (or following the introduction of the employment allowance, minimal) National Insurance cost, and to extract the remaining profits as dividends. Although dividends have to be paid from retained profits (and as such have suffered corporation tax before being paid out), this strategy was beneficial on two counts – dividends do not attract National Insurance contributions (NICs) and (for 2015/16 and earlier tax years) the existence of the 10% dividend tax credit meant that until taxable income exceeded the basic rate band, there was no further tax to pay on dividends.
All change
The rules for taxing dividends are dramatically altered from 2016/17 onwards. From 6 April 2016 onwards, the tax credit is abolished, and with it the need to perform the ‘grossing up’ calculation – the amount of the dividend actually paid is now the taxable amount. Instead, everyone will receive what is termed a dividend `allowance’ (although it is not really an allowance at all, but rather a zero rate of tax) that applies to the first £5,000 of taxable dividend income. Thereafter, dividends which are treated as the top slice of taxable income, are taxed at 7.5% to the extent that they fall in the basic rate band, 32.5% to the extent that they fall in the higher rate band and 38.1% to the extent that they fall in the additional rate band.
The incorporation decision
Whether incorporation is tax effective depends to a certain extent on the level of profits. The following examples illustrate the position at different profit levels. In each case, the profits are before salary and dividends. It is assumed that the employment allowance is not available and a salary of £8,060 (equal to the primary NIC threshold for 2016/17) is paid. The remaining profits are extracted as a dividend.
Scenario 1 – profits of £15,000
Sole trader
£
Profit 15,000
Less: personal allowance (11,000)
Taxable profit 4,000
Tax @ 20% 800
National Insurance
Class 2: 52 x £2.80 = £145.60
Class 4: 9% (£15,000 - £8,060) = £624.60
Profits retained = £15,000 - (£800 + £145.60 + £624.80) = £13,429.60
Company £
Profit 15,000
Less: Salary 8,060
Profits chargeable to corporation tax 6,940
Less: Corporation tax at 20% 1,388
Retained profits paid as a dividend 5,552
Director
The director receives a salary of £8,060 and a dividend of £5,552 – a total of £13,612. The salary and the first £2,940 of the dividend are covered by the personal allowance of £11,000. The remaining £2,612 of the dividend is taxed at 0%. Therefore, no tax is payable.
Therefore, the profits retained are £13,612.
At a profit level of £15,000, incorporation is marginally beneficial (to the tune of £182.40).
Scenario 2: profits of £40,000
Sole trader
£
Profit 40,000
Less: personal allowance (11,000)
Taxable profit 29,000
Tax @ 20% 5,800
National Insurance
Class 2: 52 x £2.80 = £145.60
Class 4: 9% (£40,000 - £8,060) = £2,874.60
Profits retained = £40,000 - (£5,800 + £145.60 + £2,874.60) = £31,179.80
Company £
Profit 40,000
Less: Salary 8,060
Profits chargeable to corporation tax 31,940
Less: Corporation tax at 20% 6,388
Retained profits paid as a dividend 25,552
Director
The director receives a salary of £8,060 and a dividend of £25,552 – a total of £33,612. The salary and the first £2,940 of the dividend are covered by the personal allowance of £11,000; the next £5,000 is taxed at the 0% rate and the remaining dividend of £17,612 (£25,552 - £2,940 - £5,000) is taxed at 7.5%, meaning the total tax payable by the director is £1,320.90 (£17,612 @ 7.5%).
Therefore, the profits retained by the director are £32,219.10,
At this level, by incorporating, more profits (to the tune of £1,111.30) are retained.
Scenario 3 – profits of £80,000
Sole trader
£
Profit 80,000
Less: personal allowance (11,000)
Taxable profit 69,000
Tax:
£32,000 @ 20% £6,400
£37,000 @ 40% £14,800
Total tax payable £21,200
National Insurance
Class 2: 52 x £2.80 = £145.60
Class 4: 9% (£43,000 - £8,060) + 2% (£80,000 - £43,000) = £3,884.60
Profits retained = £80,000 - (£21,200 + £145.60 + £3,884.60) = £54,769.80
Company £
Profit 80,000
Less: Salary 8,060
Profits chargeable to corporation tax 71,940
Less: Corporation tax at 20% 14,388
Retained profits paid as a dividend 57,552
Director
The director receives a salary of £8,060 and a dividend of £57,552 – a total of £65,612. The salary and the first £2,940 of the dividend is covered by the personal allowance of £11,000; the next £5,000 is taxed at the 0% rate, the next £27,000 @ 7.5% (= £2,025) and the remaining dividend of £22,612 (£57,552 - £2,940 - £5,000 -£27,000) is taxed at 32.5% (= £7,348.90), meaning the total tax payable by the director is £9,373.90 (£2,025 + £7,348.90).
Therefore, the profits retained by the director are £56,238.10 (£65,612 - £9,373.90)
At this level, by incorporating, more profits (to the tune of £1,468.30) are retained.
Scenario 4 – profits of £160,000
Sole trader
£
Profit 160,000
Tax:
£32,000 @ 20% £6,400
£118,000 @ 40% £47,200
£10,000 @ 45% £4,500
Total tax payable £58,100
National Insurance
Class 2: 52 x £2.80 = £145.60
Class 4: 9% (£43,000 - £8,060) + 2% (£160,000 - £43,000) = £5,484.60
Profits retained = £160,000 - (£58,100 + £145.60 + £5,484.60) = £96,269.80
Company £
Profit 160,000
Less: Salary 8,060
Profits chargeable to corporation tax 151,940
Less: Corporation tax at 20% 30,388
Retained profits paid as a dividend 121,552
Director
The director receives a salary of £8,060 and a dividend of £121,552 – a total of £129,612. As his income is in excess of £123,000 his personal allowance is fully abated.
The tax payable on the salary and dividend is as follows;
£ £
Salary £8,060 @ 20% 1,612
Dividend
£5,000 @ 0% 0
£18,940 (£32,000 - £8,060 -£5,000) @ 7.5% 1,420.50
£97,612 @ 32.5% 31,723.90
Tax on dividend 33,144.40
Total tax payable 34,756.40
Therefore, the profits retained by the director are £94,855.60 (£129,612 - £94,855.60).
At this level, the pendulum has swung the other way, in favour of operating as a sole trader (to the tune of £1,414.20.
Crunch the numbers
As the following table (which compares the profit retained at different profit levels) shows, in the current climate there is not a lot of difference and while incorporating is tax beneficial at lower profit levels, the pendulum swings the other way at high profit levels.
Profit level Sole trader Company
£15,000 13,430 13,612
£40,000 31,170 32,219
£80,000 54,770 56,238
£160,000 96,270 94,856
There is no substitute for crunching the numbers for your particular set of circumstances.
Tax tails and dogs
It is important not to let the tax tail wag the proverbial dog. There is more to consider than just tax and, indeed, a recent review of small company taxation by the Office of Tax Simplification found that tax was not the main driver for incorporation. At lower profit levels there may be less tax to pay by incorporating, but there is also more red tape when operating as a company and this may outweigh the tax savings from incorporation. On the plus side, there is the benefit of limited liability, which for many is the main reason to incorporate.
Changing status
Although there are reliefs available on incorporation and disincorporation, changing status at this juncture for reasons solely based on tax is perhaps premature. The landscape is likely to shift significantly, and until we have a better idea of when and how, it is a case of playing wait and see.
Practical Tip:
Crunch the numbers based on your particular circumstances to see whether it is tax beneficial for you to operate as a limited company or a sole trader – but don’t let the tax tail wag the dog!
