Media is certainly not falling short on inspirational start-up stories that were set up during lockdown. Having had time to reflect, it has certainly brought home to people what they really want in life. The pros and cons of different legal set ups is one of the first steps you would need to think about when setting up, so below are some key factors that may help you to decide.
Tax implications
When you have a business, usually the aim is to make profit which will be calculated by deducting business related expenses from your sales.
As a soletrader you will pay income tax and national insurance on your profits. As a Director of a limited company lot of people take “optimal” salary which is an amount around the NI threshold and the rest of the profits as dividends, because on dividends there is no National Insurance (employees’ and employers’ NI is 25.8% in total). However, before you can take any dividends, corporation tax of 19% has to be paid on company’s profits.
So, as a soletrader, if your profits are £50,000 per year in 2020/21 (6 April to 5 April) your tax bill, including NI, will be c.£11,304, meaning you will take home £38,696.
If a limited company earned £50,000 pre-tax profit before owner-Director’s salary and employers’ NI, the tax bill would be £9,854, including NI, corporation tax and tax on dividends. That means take-home pay for the owner-Director is £40,146, that is £1,450 more than what Soletrader would take home. The calculation assumes the company would not be claiming employment allowance.
We have assumed that the Director will take a salary of £9,500 as this ensures they will pay £98 employers’ NI to keep the NI record up to date, so they will not lose eligibility for state pension and other benefits.
The above are illustrative examples based on number of assumptions. In reality, number of circumstances should be considered before tax calculations are carried out.
What can you deduct as allowable expenses when calculating profits?
Even though soletraders may seemingly pay more tax they have more generous rules when it comes to allowable expenses. For example, when calculating working from home expenses, they can include rent or mortgage interest, repairs, cleaning costs, gas, electricity, water. All has to be apportioned for business use but if they can claim say £3,500, they will save lower rate tax payer £1,015 and higher rate tax payer £1,715 in tax.
Limited company owners can claim a flat fee of £6 a week without providing any evidence. If they can prove that their expenses increased considerably due to working from home, they might be able to claim more, but the process is certainly more onerous.
Here is an article that will explore working from home deductions in more detail.
Other considerations
- The key advantage of having a limited company structure is limited liability in case someone decides to sue you or make a claim. The company will be liable and not you personally.
As a soletrader you will be liable with all your assets, including your house and car.
- Another advantage of a limited company structure is more flexible tax planning. For example, if your earnings are more than £50k a year you will start losing your Child Benefit. In case of three children that would be £2,545. If your income is £60k or more, you will lose the benefit entirely. By having a limited company you can plan when you take out the dividends. By taking £50k one year and £100k the following year, you will be eligible for Child benefit every other year.
- Limited companies tend to have better timing when it comes to tax payments. As a sole trader you will have to make tax payments twice a year. As a salaried employee the tax payments are usually made monthly but as a limited company director you can set up your payroll annually. You will pay corporation tax annually 9 months and 1 day after the financial year end if your company’s profits are less than £1.5m.
- There is slightly more admin involved with a limited company, as an example accounts and confirmation statements need to be submitted annually to companies house and there is additional paper work if there are changes in directors, share transfers etc. Internally, board resolutions are required for dividend payments and any other important decisions. With additional admin comes additional cost which might offset some of the tax benefit.
- In case of any legal structures one should be careful if they freelance for one client throughout the year, not to fall into the trap of IR35. The rules around it are complex, if you are in any doubt, get in touch with an accountant who is knowledgeable about the rules and case law of IR35. In any case, it might be best to take out insurance against tax investigations.
- As we have seen with Coronavirus related government grants, it was the limited company directors with “optimal” salaries who really missed out, since dividends were not part of the grant calculations. One has to take into account several factors discussed above before deciding on the most suitable legal structure and tax planning.
Future tax increases
Government will have to recoup back the billions invested into Coronavirus grants somehow so people are anxiously looking forward to Mr Sunak’s Autumn budget in October. My personal guess is that the gap between limited company and soletrader tax bills will become closer, by reducing or fully eliminating tax free dividend band (currently £2000) and potentially increasing 7.5% basic dividend tax rate to 10%, in addition to other measures.
If you need help with any of the issues identified above, please feel free to arrange a free chat to see the ways we can help you.
Stay well!
Riina Trkulja
Web: https://www.accountsassistants.co.uk
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About us:
Riina qualified as ACA accountant when working with KPMG, then moved on to PwC due diligence practice. Her most recent job was with James Caan, the Dragons’ Den investor. She worked in his private equity business as Investment Director and also Finance Director.
She is a founder and Managing Director of AccountsAssistants.co.uk that supports small businesses by providing quality finance team outsourcing, bookkeeping, accounting and Finance Director services at reasonable rates. She also supports her clients with all the COVID related queries. She is a Fellow member of ICAEW.
