Since 1 April 2011, the tax paid by small limited companies (Corporation Tax) is the same as the basic rate of income tax – 20 per cent. In addition, the increase in Class 4 National Insurance contributions (NICs) should prompt sole traders to review their business structures for potential tax savings.
Why are you a sole trader?
Maybe you decided to be a sole trader because you thought it was easier. Deciding which business structure to go for isn’t always simple. There isn’t a ‘one-size-fits-all’ answer.
Your personal circumstances should determine your choice – and only you can decide.
Putting aside the misleading perception that a limited company gives you greater status or credibility then, in my opinion, there are two major issues to consider when deciding your business structure.
Limited or unlimited liability?
As a sole trader there is no distinction between you and your business. You do not need to have a separate business bank account. All the debts of the business are your debts. If the assets of the business do not cover the debts, your personal assets could be used to pay the debts – and that includes your house.
The debts of a limited company belong to the company, which is a separate legal entity. Except in cases where personal guarantees have been given, your personal assets will not be used to pay the company’s debts. Maybe this is a more attractive proposition than a sole trader or unincorporated business structure.
What tax do sole traders pay?
The second reason for a limited liability business is based on tax savings. As a sole trader you pay:
- income tax on profits over your personal allowance, assuming no other income
- Class 2 NICs at £2.50 per week
- Class 4 NICs on profits over £7,225 at a rate of 9 per cent up to £42,475 and 2 per cent thereafter.
If your profits are below the personal allowance of £7,475, in all likelihood it would be better to operate as a sole trader. You will pay no income tax and will only pay a very small amount of Class 4 NICs if your profits exceed £7,225.
If you profits are below £5,315, you can also apply for an exemption to Class 2 NICs.
What tax do limited companies pay?
A limited company pays Corporation Tax at 20 per cent on its profits (up to £300,000, after which the rate rises).
Profits can be withdrawn from the company by way of a salary for the director(s) and dividends for shareholders. Again, this assumes that the directors/shareholders have no other income.
Sole trader or limited company?
I’ll illustrate with an example… Say your business has profits of £15,000 and you have no other income.
Tax as a sole trader would be:
- Income tax (£15,000 – 7,475) at 20 per cent = £1,505
- Class 2 NICs (£2.50 x 52) = £130
- Class 4 NICs (£15,000 – 7,225) at 9 per cent = £700 (rounded)
Total tax = £2,335. So profits after tax are £12,665.
Tax as a limited company would be:
- Pay a salary of £589 per month = £7,068 [allowable expense from the profit].
- So the profit becomes £15,000 – 7,068 = £7,932
- Corporation Tax on the profit is 20 per cent = £1,587 (rounded)
The profit of £7,932 is distributed from the company as a dividend and no further income tax is due on the dividend, because the total income is below the higher rate threshold.
The total available after tax is the available profits + salary – Corporation Tax = £13,413. With profits of £15,000 you would be better off as a limited company to the tune of £748. If your profits are higher the savings may also increase.
Some may argue that this would be wiped out by an increase in accounting fees – I usually respond with "not if you are using CheapAccounting.co.uk".
One final thing….
There may be the opportunity to sell your sole trader business to your limited company. In doing this you may realise significant tax savings. It would be inappropriate of me to give a specific example here, because savings are absolutely dependent upon your circumstances.
So my advice is to get someone to review your circumstances and work out a specific projection for you.