As of April 1st 2011, the rate of tax levied on Limited Companies (corporation tax) is the same as the basic rate of income tax – 20%.
National Insurance Contributions were increased, and the increases, mainly in Class 4 National Insurance, should prompt sole traders to review their business structures and look into how they can reduce the amount of tax that they pay.
Are You A Sole Trader? A lot of businesses start out as a Sole Trader; mainly because starting a business is hard enough, without the added paperwork forming a limited company entails.
Deciding which business structure to take in a difficult decision to make, as a ‘one size fits all’ scenario doesn’t exist in the world of business.
Both your personal, and the business’s circumstances determine which structure would best suit you, and it is up to you to decide which route to go down; do you stay as a Sole Trader, paying more tax than an incorporated company (in some cases), or do you turn your business into a Limited company, and whilst paying less taxes, complete more paperwork?
In our opinion, there are two major issues you need to take into consideration when you’re deciding on the appropriate structure for your business:
Limited, or Unlimited Liability? When your business is a Sole Trader, there is no ‘line’ between you and your business; you are the business, and you are responsible for the business’s actions; both benefits, and liabilities.
If your Sole Trader business should get into debt, and the assets of the business won’t cover the debts, then your own personal assets could be used to pay the debts – including your house!
Incorporated companies, however, are treated as a separate legal entity to the Director – the Director is an employee of the company. If your business is incorporated and falls into debt, unless personal guarantees have been made, your personal assets will not be used to cover the company’s debts.
So, if you don’t want to risk losing your home or any other personal assets, maybe a Limited company could be the best business structure for you.
Tax – What everyone cares about! The second reason many Sole Traders consider changing their business’s entity to a Limited company is based on the tax savings.
Sole Trader’s Tax Status As a Sole Trader, you pay tax as follows:
You pay income tax on any profits exceeding your personal allowance.
Class 2 National Insurance Contributions at £2.50 per week
Class 4 National Insurance on profits over £7,225 at 9% up to £42,475. Anything over £42,475 is paid at a rate of 2%.
If your business’s profits are below your personal allowance (£7,475 for tax year 2011-2012), then it is more than likely you are better off operating as a sole trader, but make sure you confirm this with your accountant! Or, failing that, ask us for free!
Providing your profits are still under your personal allowance, you will only pay no income tax, and a minimal amount of class 4 national insurance contributions if your profits are over £7,225.
You can apply for an exemption to class 2 national insurance contributions if your profits for how to form a limited company the tax year are under £5,315.
Limited Company’s Tax Status A Limited company, provided the profits are below £300,000 (where the higher rate of corporation tax kicks in), will pay 20% corporation tax on its profits.
Profits can be withdrawn from the company by way of dividends for shareholders, and salary for directors – this is assuming that the directors/shareholders have no other income. Obviously, you can be both a director and shareholder of the company at the same time.
So, the question is, which is best?
Tax-wise, this can be shown in an example:
For the example, both Sole Trader 1 and Limited Company 1 have £20,000 profits from the tax year, with no other income present.
Sole Trader 1 pays tax as shown below: Income Tax (£20,000 – £7,475) at 20% = £2,505
Class 2 National Insurance (£2.50 x 52) = £130
Class 4 National Insurance (£20,000 – £7,225) at 9% = £1,149.75
So, with £20,000 profit, the total amount of tax Sole Trader 1 pays is £3,784.75
Limited Company 1 pays tax as shown below: Limited Company 1 pays a salary of £589 per month to its director, which is the maximum it can pay without the director being subject to income tax (provided the director has no other income). So, £589 x 12 (months) = £7,068.
NOTE: If you are a Limited company’s director, and are still paying yourself £476 per month, you can increase it to £589 per month as of April 2011.