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Should you still advise growing businesses to incorporate?

29th Mar 2023
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The Autumn Statement clarified what changes affecting small company owners’ profit extraction would be retained. As we head into 2023/24, what are the key points, and is incorporation still worthwhile for growing businesses?

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What's the correct trading vehicle?

If your client chooses to operate via a limited company, it's a separate entity and will pay corporation tax (CT) on its profits. If the client wishes to use those profits outside the company, they must be extracted. There are various options here, but a popular profit extraction strategy is to take a small salary plus dividends. Depending on the level and the client’s other income, the client may pay income tax and employees’ NI and the employer may pay employers’ NI. However, the salary level is usually set to minimise NI.

Dividends can only be paid out of retained profits, and the profits from which dividends are paid have already suffered CT. Dividends are taxed at a zero rate to the extent that they are sheltered by the dividend allowance and any unused personal allowance. Thereafter, they are taxed at the appropriate dividend tax rate, being treated as the top slice of income.

What's new from April?

 From April the main CT rate is 25% for a standalone company with profits in excess of £250,000. A small profits rate, equal to the current rate of 19%, applies where profits are £50,000 or less. Between these rates, the effective rate is between 19% and 25%, being calculated at 25% of taxable profits, less marginal relief. The increase will not affect standalone companies whose taxable profits are £50,000 or less. However, personal and family companies with taxable profits exceeding this will pay more corporation tax from April 2023. This will reduce the profits available to extract as dividends.

Dividends

The dividend allowance has also reduced from 6 April 2023, to £1,000 from the previous level of £2,000. This will reduce the dividends that can be extracted tax free and reduce the benefit of an alphabet share structure to utilise the dividend allowance of family members. The dividend rates, increased by 1.25% from 6 April 2022 as part of a package of health and social care measures, will remain at this level, despite the cancellation of the Health and Social Care Levy and temporary NI increase. The dividend tax rates for 2023/24 remain at 8.75% where dividends fall in the basic rate band, at 33.75% where dividends fall within the higher rate band and at 39.35% where dividends fall in the additional rate band.

How are owner managers affected?

Let’s look at the impact this will have on the company v sole trade comparison, assuming a profit extraction strategy consisting of a salary of £12,570 and all remaining profits extracted as dividends. Note that this may not be the optimum strategy, we are simply making the assumption to keep things simple for the purposes of comparison.

The tax and NI payable by a single director company and individual at three profit levels are shown below:

 

£

£

£

Profit

55,000

120,000

270,000

Salary

(12,570)

(12,570)

(12,570)

ERs’ NI

(479)

(479)

(479)

Taxable

41,951

106,951

256,951

CT

(7,971)

(24,592)

(64,238)

Dividend

33,980

82,359

192,713

Income tax

(2,886)

(18,283)

(65,673)

In-pocket position

43,664

76,646

139,610

The personal allowance is fully abated once adjusted income exceeds £125,140, meaning that once income reaches this level, tax is paid on the first £1 of income (subject to dividends covered by the dividend allowance). The dividend allowance will fall again in April 2024, to just £500.

Now let’s look how the sole trader will fare at the same profit levels:

 

£

£

£

Profits

55,000

120,000

270,000

Personal allowance

(12,570)

(2,570)

0

Taxable

42,430

117,430

270,000

Income tax

(9,432)

(40,232)

(107,703)

Class 2

(179)

(179)

(179)

Class 4

(3,488)

(4,776)

(7,788)

In-pocket position

41,901

74,813

154,330

Conclusion?

The comparison paints a similar picture to the position that has been prevalent since the changes to dividend tax in 2016 - namely that incorporation is still worthwhile at relatively modest profit levels, but once profits increase significantly, the sole trader will retain more.

Additionally, it is worth noting that the advantages are quite small. At the two profit levels where the company owner is better off, the difference is only approximately £1,600. As companies are subject to a higher administrative burden than unincorporated businesses, the relatively small savings might not be enough to consider incorporation for tax/NI reasons alone. However, that doesn’t mean incorporation should be off the table. There are a number of factors you will need to consider when advising clients:

  • the examples assume all profits are extracted. A better result could be achieved by restricting this, e.g. so that the director shareholder does not enter the personal allowance abatement range
  • the company example is based on a single director shareholder. Things could be greatly improved if multiple tax allowances and basic rate bands could be used, e.g. by having a spouse/civil partner as a second shareholder
  • the examples assume there is no other income. In reality, this would need considering so an optimal profit extraction strategy can be devised.

The overall conclusion is that while incorporation can still offer tax and NI savings, there is no one-size-fits-all solution, and you should tailor your advice to clients based on their own individual circumstances. Additionally, there are numerous non-tax incentives for incorporating, including: the benefits of limited liability to protect personal assets; perceived prestige; ensuring continuity of the business in perpetuity; ease of succession planning.

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