Confessions of a Recovering MLM Junkie

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 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. œ31,063
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
œ34,515), 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
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 the above, let's take a simple example. We
have a limited company and a sole trader. They both make
œ60,000 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 œ4,615 and the
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 the 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
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 œ10,000 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 œ3,600 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.
œ4,615.

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
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on a variety of interesting topics.

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more of your hard earned cash stays with you to expand your
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