Sole Trader V Limited Company

Introduction

One question that I am frequently asked as an accountant concerns the issue on deciding whether to trade as a limited company or sole trader. Knowing when to incorporate is not an exact science. Apart from the savings on tax and national insurance contributions there are many other factors to consider and incorporation is not always the best solution.

Whilst most business people will be concerned with increasing their “take home pay” so to speak, another big benefit from incorporation is the concept of limited liability. This means that in the event of the company winding up the owners will only be liable to the amount of their share capital. However, incorporation is generally not advantageous where profits are low. Moreover, compliance costs are generally more expensive for a company as it is required to file formal accounts and a corporation tax return with HMRC, together with abbreviated accounts and an annual return with Companies House.

Trading as a Sole Trader

As a sole trader you are charged income tax on your business profits, which is your turnover less your allowable expenses; you will pay class 4 national insurance contributions at 9% on profits above £8,060 and 2% on profits above £42,385 in 2015/16. You will also have to pay Class 2 NICs at a fixed rate, currently £2.80 per week on profits above £5,965.

Unlike with a company, any salary taken by the business owner is treated as drawings and is not an allowable expense for tax purposes. This can mean an effective high rate of tax. Let’s consider an example, Matthew a sole trader has profits of £60,000 for the current tax year. His total tax and NI bill for the year will be £16,990 – an effective rate tax rate of 28.3% regardless of whether he actually takes drawings from the business.

Trading as a Limited Company

Through transferring a business to a company income tax is only charged when money is taken out of the company which means you can maximise use of the lower tax rate band and tax free allowance. You can also take pay by way of dividends which attracts a lower tax rate than income tax.

However, dividends are an appropriation of profits meaning they are not an allowable expense for tax purposes. Company profits are chargeable to corporation tax which is currently 20%. Maximum dividends will therefore be 80% of profits.

The position can be further complicated because just taking a dividend is not the most tax efficient route. Unlike a salary, dividends are not subject to NI and so taking these alone may leave you short in your NI contributions history at retirement, which will adversely affect your entitlement to state pension and other benefits. Under existing rules you need a full 35 year contribution history to qualify for the maximum state pension.

Maximising Your Position through a Limited Company

To ensure your NI contribution history is maximised and thus your entitlement to full state pension is secured you can take a minimal salary and the rest as dividends. Although paying a salary above the lower earnings limit, currently £112 per week will attract both employees and employers NIC’s these can be offset by the employment allowance worth up £2,000 in 2015/16.

For the current financial year the most tax efficient salary for the one person band is £10,600 taking the rest as dividends during the year. Using the same profit figure of £60,000 as in the example above, if Matthew takes a salary of £10,600 and the rest of the post corporation tax profits as dividends, after tax and NI the amount of cash he will have available is £47,086. An effective tax rate of 21.5% compared to 28.3% as a sole trader.

At Ovenden Booking and Accounting Services are aim is to save our clients more in tax than they pay for using our services. We have the expertise to assist you in deciding whether the sole trader or company route is best for you now, or at some time in the future. For further details please phone Alan Ovenden on 01255 483494 or email a[email protected].

Posted in Compliance Limited Salary PAYE Sole Trader at 2015-10-04 by Alan Ovenden

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