Fonts: How To Choose Between Them

The answer is that from a tax point of view, it isadvantageous to trade through a limited company as longas the income is drawn from the company by the owners asdividends from their shares and the amount of dividendsdrawn is restricted below the 40% band rate (i.e. œ31,063for tax year 2002/03). That way, the owners have no furtherpersonal tax ("income tax") to pay. Moreover, dividends arenot subject to national insurance contributions. This isexcellent news of course. But, if dividend income fallswithin the higher rate bracket of income tax (i.e. aboveœ34,515), they will be taxed at 22.5% on the excess, whichof course will increase the tax burden. The company profitsare subject to corporation tax rates. Those are lower thanincome tax rates.

The most catastrophic scenario is when the director takeshis reward from the company as salary. Then his/her salaryis taxed at income tax rates (like a sole trader's income).That is because, unlike sole traders, the tax system treatscompanies as separate from their owners because a company isa separate legal entity. The problem is that the incometaxes are higher than corporation tax rates. On top ofthat, they will be subject to employee and employer nationalinsurance contributions, which of course increase the taxburden and render his position worse than even anunincorporated business ("sole trader"), because NIC Class 1on payroll are higher than NIC Class 2 paid by selfemployed.

In contrast, a self employed person ("sole trader") is taxedat income tax rates on the profits from his business, whichare added to his other sources of income. As it has alreadybeen mentioned, income tax rates are overall higher thancorporation tax rates. On top of income tax, nationalinsurance contributions class 4 are payable on the businessprofits within a specified band (7% on profits betweenœ4,615and œ30,420). National insurance contributions Class 2are also paid by self-employed people, although those arelower than those payable by company directors on theirsalaries.

To illustrate the above, let's take a simple example. Wehave a limited company and a sole trader. They both makeœ60,000 profits each in the tax year 2002/03. We assume thatthe company director takes a salary equal to the amount ofhis personal allowances (untaxed income) of œ4,615 and thebalance as dividends. The company will pay corporation taxat 19% equal to œ10,523 and nothing else. The sole traderwill pay income tax œ16,542, National insurance Class 2 œ104and National insurance Class 4 œ1,806. Total œ18,452. Thebottom line is that the person that has incorporated hisbusiness into a limited company will make a tax saving ofœ7,929 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 helpthe economy grow, encourages people to leave as much profitswithin their businesses to be reinvested, instead of beingtaken out and spent.

The "unofficial line" is that, as a matter of fact, foryears the Inland Revenue has tried to reclassify theself-employed. The 1% in NIC hike on staff salaries abovethe NIC threshold from next April adds to both theemployees' and employers' tax burden and may more thanoffset the saving from the corporation tax zero rate on thefirst œ10,000 of profits.

Aren't there any other matters to consider in decidingwhether to incorporate or not?

Higher administration costs to comply with company law,payroll and bookkeeping is one factor. Another issue ispension planning. Extracting profits out of the company asdividends rather than salary means that there will be no"net relevant earnings" and therefore pension contributionscan't be made. But the advent of stakeholder pension planshas meant that contributions up to œ3,600 per year can bemade without the need for any earnings. If a person does notwish to transfer funds in existing plans into stakeholderbecause of high charges, there is a way out: the best netrelevant earnings (i.e. salary) in five consecutive yearscan be used for making contributions for the next fiveyears, even if there were no salaries in the remainder fouryears. It is comforting to know that entitlement to basicstate pension is not affected by taking a salary from thecompany at the level of a person's personal allowances i.e.œ4,615.

Furthermore, an individual may decide not to bother withpension plans and instead invest in ISA. Often, these can bemore efficient than pensions but that's beside the scope ofthis article. If that option is taken, no salary isnecessary.

Another factor is business motoring. It might be taxadvantageous for an unincorporated business that owns manycars not to incorporate because if these cars have someprivate use there will be benefits in kind taxed on theusers. These are generally higher than the straightapportionment between private and business for all carrunning costs in the case of sole traders.

The conclusion is that there can be considerable tax savingswaiting the sole trader who decides to go down theroad to incorporation. But, one needs to proceed withcaution and careful planning. And don't forget the biggestadvantage of incorporation, which is Protectionfrom Personal Liability. Incorporating is one of the bestways to protect a business owner from personal liability.Shareholders of a company are generally not liable for theobligations of the company. Creditors of a company may seekpayment from its assets, but not the assets of theshareholders. This means that business owners may engage inbusiness without risking their homes or other personalproperty.

Thank you for taking the time to read this Article. I hopeyou've found it useful. If you have, please drop me an emailand let me know what you think.

You can email me at...

constantinesavva@accamail.com

Alternatively, you can visit our website athttp://www.tax-accounting-london.info and read a series ofother full length articles that present the complete pictureon a variety of interesting topics.

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