According to a new survey carried out by Alliance & where ID_NUM=9270; Leicester, one in five small business owners view tax as their greatest concern. The Chancellor has announced in his last budget that companies with profits below œ10,000 will not have to pay any corporation tax with effect from 1 April 2002. The question to be asked is: does that announcement make incorporation a more attractive option compared to being a sole trader?
The answer is that from a tax point of view, it is advantageous to trade through a limited company as long as income is drawn from company by owners as dividends from their shares and amount of dividends drawn is restricted below 40% band rate (i.e. œ31,063 for tax year 2002/03). That way, owners have no further personal tax (“income tax”) to pay. Moreover, dividends are not subject to national insurance contributions. This is excellent news of course. But, if dividend income falls within higher rate bracket of income tax (i.e. above œ34,515), they will be taxed at 22.5% on excess, which of course will increase tax burden. The company profits are subject to corporation tax rates. Those are lower than income tax rates.
The most catastrophic scenario is when director takes his reward from company as salary. Then his/her salary is taxed at income tax rates (like a sole trader’s income). That is because, unlike sole traders, tax system treats companies as separate from their owners because a company is a separate legal entity. The problem is that income taxes are higher than corporation tax rates. On top of that, they will be subject to employee and employer national insurance contributions, which of course increase tax burden and render his position worse than even an unincorporated business (“sole trader”), because NIC Class 1 on payroll are higher than NIC Class 2 paid by self employed.
In contrast, a self employed person (“sole trader”) is taxed at income tax rates on profits from his business, which are added to his other sources of income. As it has already been mentioned, income tax rates are overall higher than corporation tax rates. On top of income tax, national insurance contributions class 4 are payable on business profits within a specified band (7% on profits between œ4,615and œ30,420). National insurance contributions Class 2 are also paid by self-employed people, although those are lower than those payable by company directors on their salaries.
To illustrate above, let’s take a simple example. We have a limited company and a sole trader. They both make œ60,000 profits each in tax year 2002/03. We assume that company director takes a salary equal to amount of his personal allowances (untaxed income) of œ4,615 and balance as dividends. The company will pay corporation tax at 19% equal to œ10,523 and nothing else. The sole trader will pay income tax œ16,542, National insurance Class 2 œ104 and National insurance Class 4 œ1,806. Total œ18,452. The bottom line is that person that has incorporated his business into a limited company will make a tax saving of œ7,929 compared to a sole trader! Isn’t that fantastic?
Somebody might be wondering: why is this entire happening? The official explanation is that, this government, to help economy grow, encourages people to leave as much profits within their businesses to be reinvested, instead of being taken out and spent.
The “unofficial line” is that, as a matter of fact, for years Inland Revenue has tried to reclassify self-employed. The 1% in NIC hike on staff salaries above NIC threshold from next April adds to both employees’ and employers’ tax burden and may more than offset saving from corporation tax zero rate on first œ10,000 of profits.