TAKE ADVANTAGE OF ADWORDS
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 10,000
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 the income is
drawn from the company by the owners as dividends from their
shares and the amount of dividends drawn is restricted below the
40% band rate (i.e. 31,063 for tax year 2002/03). That
way, the 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 the higher rate bracket of income
tax (i.e. above 34,515), they will be taxed at 22.5% on
the excess, which of course will increase the tax burden. The
company profits are subject to corporation tax rates. Those are
lower than income tax rates.
The most catastrophic scenario is when the director takes his
reward from the 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, the tax system treats companies as
separate from their owners because a company is a separate legal
entity. The problem is that the 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 the 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 the 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 the business profits within
a specified band (7% on profits between 4,615and
30,420). 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 the above, let's take a simple example. We have a
limited company and a sole trader. They both make 60,000
profits each in the tax year 2002/03. We assume that the company
director takes a salary equal to the amount of his personal
allowances (untaxed income) of 4,615 and the balance as
dividends. The company will pay corporation tax at 19% equal to
10,523 and nothing else. The sole trader will pay income
tax 16,542, National insurance Class 2 104 and
National insurance Class 4 1,806. Total 18,452. The
bottom line is that the person that has incorporated his
business into a limited company will make a tax saving of
7,929 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 the
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
the Inland Revenue has tried to reclassify the self-employed.
The 1% in NIC hike on staff salaries above the NIC threshold
from next April adds to both the employees' and employers' tax
burden and may more than offset the saving from the corporation
tax zero rate on the first 10,000 of profits.
Aren't there any other matters to consider in deciding whether
to incorporate or not?
Higher administration costs to comply with company law, payroll
and bookkeeping is one factor. Another issue is pension
planning. Extracting profits out of the company as dividends
rather than salary means that there will be no "net relevant
earnings" and therefore pension contributions can't be made. But
the advent of stakeholder pension plans has meant that
contributions up to 3,600 per year can be made without the
need for any earnings. If a person does not wish to transfer
funds in existing plans into stakeholder because of high
charges, there is a way out: the best net relevant earnings
(i.e. salary) in five consecutive years can be used for making
contributions for the next five years, even if there were no
salaries in the remainder four years. It is comforting to know
that entitlement to basic state pension is not affected by
taking a salary from the company at the level of a person's
personal allowances i.e. 4,615.
Furthermore, an individual may decide not to bother with pension
plans and instead invest in ISA. Often, these can be more
efficient than pensions but that's beside the scope of this
article. If that option is taken, no salary is necessary.
Another factor is business motoring. It might be tax
advantageous for an unincorporated business that owns many cars
not to incorporate because if these cars have some private use
there will be benefits in kind taxed on the users. These are
generally higher than the straight apportionment between private
and business for all car running costs in the case of sole
traders.
The conclusion is that there can be considerable tax savings
waiting the sole trader who decides to go down the road to
incorporation. But, one needs to proceed with caution and
careful planning. And don't forget the biggest advantage of
incorporation, which is Protection from Personal Liability.
Incorporating is one of the best ways to protect a business
owner from personal liability. Shareholders of a company are
generally not liable for the obligations of the company.
Creditors of a company may seek payment from its assets, but not
the assets of the shareholders. This means that business owners
may engage in business without risking their homes or other
personal property.
Thank you for taking the time to read this Article. I hope
you've found it useful. If you have, please drop me an email and
let me know what you think.
You can email me at...
constantinesavva@accamail.com
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http://www.tax-accounting-london.info and read a series of other
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