New Dividend Tax – Can I still save tax by operating through a limited company?
An important question often asked by many small business owners is how to structure their business. A UK business can generally be structured as a sole trader, partnership or a company. Sole traders and partnerships are pretty much taxed in the same way, by adding the profits of the business to the owner’s other income, which is then subject to income tax and national insurance contributions. Companies, however, pay corporation tax on their profits and any money taken out of the company by the owners may also be subject to income tax and national insurance contributions.
The sole trader v limited company question has been around for some time. In the past Governments have given big tax incentives that encouraged many small business owners to incorporate their businesses. In fact, in financial years 2002 to 2005 sole traders with profits of around £15,000 could incorporate their business and avoid paying corporation tax and income tax altogether; due to the very generous 0% tax band on small company profits. Over the years, however, these tax savings have become less generous. The latest tax change from 6 April 2016 is the new dividend tax rules. These new rules will see a further eroding of the tax advantages of operating via a company.
There are of course many good reasons to structure a business as a company such as: limited liability protection; as a tax shelter, by retaining profits within the business; obtaining certain reliefs only available to a company etc. However, many of the incorporations that have happened over the years, in my view, have been mainly motivated by tax savings.
Many small businesses have rushed to incorporate to save tax without considering the disadvantages. As the company is a separate legal entity and is governed by the Companies Act 2006 (CA 2006), there is a substantially greater administrative burden to running a company than any other form of business. Furthermore, some breaches of the CA 2006 requirements are criminal offences.
Due to the new dividend tax rules many small businesses are naturally concerned with the additional tax burden placed on them, and whether the additional costs of operating their business as a company still outweigh the tax savings. The table below compares the tax savings at various profit levels for 2015/16 and at 2016/17 when the new dividend tax rules kick in. The figures make various assumptions such as a small salary of £8,060 being paid and then all remaining profits being distributed as a dividend. Class 2 NIC has been included in both tax years, although it will be scrapped in 2018. Other factors should also be taken in to account such additional accountancy fees that would be chargeable over operating as a company instead of a sole trader as well as other points noted above.
Estimated tax savings by operating as a company instead of a sole trader
As you can see from the table above, at profit levels between £20,000 – £40,000 and £75,000 to £100,000, it’s really not worth incorporating purely for tax saving reasons alone in 2016/17. Once the additional accountancy fees from operating as a company rather than a sole trader are also taken in to account, any small savings in tax are wiped out. In my view, only at a profit level of around £50,000, can it still be argued that there’s any tax saving benefit from incorporating a business. However, as corporation tax rates are due to fall from 20% to 17% by 2020 we may well see the tax savings starting to creep up again.