Tax advantages of incorporating a business
Running a small business as a sole trader has plenty of advantages, the alternative is to create a limited company form which to run your business from. This article compares how setting up a limited company affects individual’s tax liability in 2019/20. It is important to note, that levels of profit are an important factor when deciding whether to incorporate or run a business from a sole trader position.
In this illustration we will use a figure of £72,000 as a profit figure for the year. The table following table shows the varying tax treatments regarding remuneration paid out to from a limited company to that levied on a sole trader:
Limited Liability Company “ABC Ltd” Set up by Mr X | Sole Trader Mr Z |
£72,000 profit declared | £72,000 profit declared |
ABC Ltd pays Mr X a basic salary of £8,632. | All of the profits deemed as income for Mr Z |
A low salary paid out prevents any national insurance contribution payments arising. This salary translates to an expense in company accounts and reduces ABC Ltd taxable profits to £63,368. | Any expenses incurred by Mr Z are not deductible from profits for the year as Mr Z and his business are treated as one entity. |
ABC Ltd is required to pay 19% corporation tax on all profits. The corporation tax bill amounts to £12,040. ABC Ltd cash in bank – £51,328 At this stage, ABC Ltd can distribute all profits to shareholders as dividends (in this case Mr X holds all shares). This will increase Mr X’s total income to £59,960 | No corporation tax payable. |
Mr X still has £3,868 of his tax-free personal allowance available. Further to that, £2,000 tax free dividend allowance is available. ABC Ltd can pay out £5,868 to Mr X in dividends with no tax liability arising to him. | No dividends paid = dividend allowance wasted. |
Mr X will pay basic rate dividend tax on income between £14,500 to £50,000. £35,500 at 7.5% – £2,663 The rest of Mr X’s income will be charged at higher rate dividend rate of 32.5%. £9,960 at 32.5% – £3,237 | Personal allowance of £12,500 – no tax paid Basic rate band – 20% on the next £37,500 – £7,500 Higher rate band – 40% on the next £22,000 – £8,800 Mr Z’s total tax liability – £16,300 |
ABC Ltd pays no National insurance contributions. | Class 2 National insurance contributions – £156 Total National insurance contributions – £4,319 |
Total tax liability for Mr X – £5,900 Total tax liability for ABC Ltd – £12,040 | Total tax and NIC paid by Mr Z – £20,619 |
Mr X cash in bank – £54,060 | Mr Z cash in bank – £51,381 |
As you can see from the comparison above, being incorporated will produce a saving of £2,679. While incorporating your business can be tax efficient, it’s important to remember that it isn’t necessarily the best approach for everyone, mainly those whose profits do not exceed the personal tax-free allowance. Professional advice is recommended to ensure that a right decision is made.