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CPAA Insight: Going Limited? Steve Willis considers the tax advantages of incorporation

4th Oct 2013
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This article first appeared in the September 2013 edition of CPAA's membership magazine, Practising Accountant.

IN 2013/14 A SHAREHOLDER/DIRECTOR whose company shows a profit of £41,450 will be able to take a tax-free salary of £7,755 plus gross dividend payment of £33,695 (cash dividend of £30,325). This will give a tax-free income of £38,080. His company will pay £7,581 in Corporation Tax (£37,906 - 20% = £30,325) plus £8 NI (£7,755 - £7,696 x 13.8%). 

A self-employed sole trader showing the same profit will pay £9,574 plus half as much again, £4,787, on account - a difference of £1,985 plus the loss of £4,787 cash flow for a year. The £4,787 on overdraft could add another £239 to the business costs instead of earning a couple of interest points on deposit. 

The same company shareholder/director could have his £1,500 golf club subscription paid for by his company as part of his remuneration package thereby saving him £250 in VAT and £180 NI leaving only £300 to pay in tax. 

This company will pay NI on the benefit-in-kind but save corporation tax on the payment and NI and recover the VAT which, as payment of the golf subs, forms part of the remuneration package, a part of the employee’s pay – therefore a legitimate business expense. 

His self-employed golfing partner will have to pay tax and NI of 29% on £2,113 (£613) in order to be left with £1,500 to pay for the subs that will include £250 VAT. Total tax and NI paid by the sole trader will be £863 and won’t count as a business expense for tax deduction.

A no brainer - or not?

Perhaps the tax advantage of incorporation is a no-brainer for businesses with profits over £40k but what about all the thousands of small businesses with profits between £10k - £40k; at what point does the tax advisor recommend the use a limited company?

The decision is not a simple ‘yes’ or ‘no’. There is not a single point or line that when reached triggers a ‘yes’ button. Instead there are several tax and NI bands, thresholds and rates to juggle with that determine how much a taxpayer must pay. 

Choice of options

One big advantage of incorporation is that it gives the taxpayer and his advisor a choice of options as to which tax bands and rates will apply.

For businesses with profits between £20k and £100k, the advantage of a limited company will depend on the mix of salary, dividends and benefits-in-kind used, bearing in mind the benefits that a paid salary brings i.e. a 20% tax deduction for the company, effectively only costing it 80% of the cash value leaving more to pay out as dividends, the salary counts towards earned income for pension and tax credits and secures the minimum contribution for state pension.

Thresholds to consider

The three popular thresholds used in determining the best mix are:

  • £7,696 the NI company threshold: 

Below this figure neither the company nor the individual pays NI, saving the need to operate PAYE – a huge benefit

  • £7,755 the individual’s NI threshold: 

At this level the company will pay NI on £59 but the individual is free of tax and NI. PAYE will need to be operated on by the company

  • £9,440 the tax-free personal allowance:

At this level of salary both company and individual will pay NI but it is free of tax for the individual – assuming no other income

When applied to cohabiting directors or company office holders these thresholds offer a very tax efficient means of spreading a business profit between them as they have both control and benefit of their decisions. 

The benefits can be doubled for cohabiting couples. The £7,696 threshold would give a couple an income of £15,392 free of tax, NI and PAYE for an effective cost of only £12,314. This, along with the different rules and regulations that govern corporation and income tax, gives a lot more opportunity for incorporated taxpayers to minimise their tax liability. 

Dividends, cohabitees & couples

Another great advantage offered by incorporation is the dividend payment that comes tax-free to shareholders whose total income is below £41,450.

The dividend income paid to the shareholder is unconnected to their involvement in the company (see the ruling in Arctic Systems Ltd) therefore since there needs to be at least two ‘participators’ in a company who could both be and usually are, shareholders, this offers cohabiting couples double the tax-free benefit available to the individual shareholder i.e. £82,900. 

There is no such luxury for the self-employed. The only option for them is to either form a business partnership with the cohabitee or pay them a salary. The problem with a partnership is that although the partners can choose the ratio in which to share the profit, any loss sustained will be shared in the same ratio. Stockholders don’t have this problem. 

In the case of a partnership making a profit, each partner will pay tax and NI at 29%, 42%, 62%, and 47% up to and beyond £150k according to the value of their share. 

A limited company will pay only 20% up to £300k. Admittedly the limited company’s post tax balance has yet to be extracted for the shareholders to spend on themselves but a far greater amount remains in the bank to run the business with. 

With regard to paying a cohabitee a salary, the problem here is that the payment must be justifiable, that is to say, the service paid for must have been provided, at the market rate by the service provider who must be capable and available to provide the service. Members of parliament have often been caught out by claiming payments to relatives that on inspection could not justify the performance of the service paid for.

The ability to be able to withdraw a company’s profit in different forms e.g. salary, bonus, dividend, benefits-in-kind and loans helps the owner/shareholder to avoid some of the latest punitive tax thresholds, for example, the £50,000 Child Benefit tax charge and £100,000 Personal Allowance Withdrawal. 

A director can reduce or postpone a salary or dividend payment if necessary to avoid a particular threshold always knowing that the profit remains in the company until required.

This raises yet another advantage of a limited company over a sole trader namely that of maintained residual value of profits after tax.

Take for example a sole trader and a limited company that both make £75,000 profit. The sole trader will pay £23,666 in tax and NI leaving £51,334 to spend or use to expand the business. 

The limited company will pay only £15,000 in tax leaving it with £60,000 to run its business. If they were both running on overdraft the sole trader would have an extra £8,666 to fund which at say 5% would add an additional £433 to the business expenses.

The tax and NI data is complex and probably beyond the understanding of the layperson. This puts a greater responsibility on the professional tax advisor to guide his client through the maze of incorporation pros and cons that he is bound to do under the terms agreed in his client’s engagement letter.

Loans

One final advantage for a couple who are company shareholder/directors in the same company, is that the company can lend them interest free £5,000, £10,000 combined, which after 6 April 2014 becomes £10,000 each, £20,000 combined. 

These loans are exempt from the benefit-in-kind rules and so no interest need be charged on them. They must be repaid within 9 months from the end of the company’s accounting year-end, thus giving a loan period of 21 months. During this time the money could be invested in a tax-free ISA or in premium bonds with a chance to win £1 million - all from a tax-free company loan. Sadly this is yet another option not available to the self-employed.

About the Author:

Steve Willis is author of Tax Advantages of a Limited Company and The Benefit of Benefits-in-Kind* both available from Willis Publications.

*FREE to CPAA members with Tax Advantages of a Limited Company priced £19.95.

Willis Publications, 16 Dunston Rd, Metheringham, Lincs LN4 3ED

email:  [email protected] Tel:01526 320035 Fax: 01526 320305.

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