Over the last few years numerous sole traders and partnerships have ceased to trade as self-employed and instead are now trading through a limited company.
The main reason for incorporating your business has been the substantial tax savings that can be achieved by transferring a profitable business to a limited company. These tax savings are shown in the examples below:
A sole trader has a taxable profit of £35,000 for the year ended 31 March 2015. (As a sole trader you pay income tax on the paper profit per the accounts as adjusted for tax and not what you have actually drawn from the business).
Taxable profit £35,000
Less : personal allowance (£10,000)
Income on which tax is due £25,000
Non savings income @ 20% £5,000
Class 4 national insurance
(£35,000 – £7,956) @ 9% £2,433.96
Liability to income tax and class 4 NI £7,433.96
If we assume the same profits are made in a limited company, the tax scenario is very different.
The company pays corporation tax on the tax adjusted profit per the accounts but, as a director, you are deemed to be an employee of the company and, as a shareholder, you are an investor who can receive dividends if they have been voted and administered correctly.
Company profit £35,000
Less : salary to director (£7,800)
Company taxable profit £27,200
Corporation tax @ 20% £5,440
Hence there is a substantial tax saving each year, let alone when you consider the life of a business.
As a director you have your employment salary of £7,800 (which is below the threshold for paying NI but still obtains the benefits such as a qualifying year for a state pension).
Furthermore, as a shareholder (assume 100%) the company has available profits, after tax, for distribution of £27,200 so this could all be voted as a dividend for the shareholder, who would be drawing £35,000.
As dividends are deemed to have been received with the deduction of a 10% tax credit, the salary is covered by your personal allowance and the dividend is deemed to have been taxed at source, so there is no personal tax liability at all.
If you choose to incorporate there is also the possibility of selling the goodwill of your business to the company, which can be tax efficient.
However, a limited company is a separate legal entity – the money in the company bank account belongs to the company and not the director/shareholder.
The cost of preparing company accounts is higher as there is much more information to disclose, and then an abbreviated version of the accounts have to be filed at Companies House, meaning that they are on public record.
These are key things to bear in mind when considering incorporation.