Before starting a new business consideration must given to the vehicle with which the business will be conducted.
The article below compares the key tax differences between the two main businesses forms, the sole trader/partnership and the limited company, and where tax efficiencies may be made.
For the purpose of this note it is assumed that company shareholders and the members of partnerships are all individuals. It should be noted that corporate shareholders or corporate members of a partnership may be taxed differently to individuals. One such example is a UK dividend which would not generally be taxable when received by another UK company.
Remuneration
The vehicle adopted and, in the case of a corporate the method of profit extraction, will impact on the effective rate of tax payable on profits once in the hands of shareholders/members.
This ‘effective rate of tax’ varies depending on the level of profit.
Summary
In simple terms, for pre tax profits below £367,530, profit level at which the dividend (blue) and sole trader (green) traces converge, dividend extraction from a limited company is the more tax efficient option. Beyond this profit point a sole trader vehicle (or partnership/LLP) would be the more tax efficient vehicle.
Extracting profits from an incorporated entity by means of salary (red line) is at all times the more expensive option.
To explain why this is the case it useful to look at the make up of total tax charge. At a pre tax of £100,000 the income tax payable by the sole trader is the same as the income tax/corporate tax payable by an owner manger of a limited company (29.9%/29.8%). However, as a sole trader is also subject to national insurance (which dividends are not) this adds a further 3.6% to the total tax charge.
| Illustration 1 – Effective rates at a pre tax profit of £100,000 |
| |
Sole Trader |
CompanyDividend |
CompanySalary |
| Income tax |
29.9% |
8.8% |
25.7% |
| Corporation tax |
– |
21% |
– |
| National Insurance |
3.6% |
– |
15.3% |
| Total |
33.5% |
29.8% |
41% |
Where profits increase to £500,000, the limited company no longer qualifies for the small companies’ rate. This adds a further 3.5% to the effective corporation tax rate.
In addition, because the full rate of National Insurance payable by the sole trader (8%) only applies to profits up to £43, 875 (2009/10), the impact of National Insurance as a proportion of the total tax charge decreases as profits increase.
At £500,000 the National Insurance makes up only 1.5% of the sole trader’s total tax charge.
| Illustration 2 – Effective rates at a pre tax profit of £500,000 |
| |
Sole Trader |
Company – Dividend |
Company – Salary |
| Income tax |
38% |
16.7% |
33.5% |
| Corporation tax |
– |
24.5% |
– |
| National Insurance |
1.5% |
– |
12.9% |
| Total |
39.5% |
41.2% |
46.4% |
Remuneration strategy
While this chart illustrates the relative position of each vehicle, it is important to note that this is a pure tax comparison and the actual remuneration strategy you will adopt will generally be determined by a number of factors including:
- mitigating the impact of costly NICs;
- the need to make a suitable pension provision;
- the anti-avoidance rules for taxing income of personal service companies;
- the possible commercial need to retain a specific level of profits;
- meeting the national minimum wage requirements;
- the requirements of a shareholders’ agreement;
- the possible need to keep directors’ remuneration within the limits imposed by a lending bank; and
- the working shareholders’ personal spending requirements.
Remuneration by dividend and the impact on private pensions
There is no limit on the amount that an individual can contribute to a registered pension scheme each year, however, there is a limit on the amount of contributions eligible to tax relief.
The maximum annual contribution on which tax relief is in any year is currently the greater of £3,600 and 100% of relevant UK earnings for that year. Taxable earnings broadly include employment income and benefits but importantly not dividends and investment income.
Remuneration by dividend and the impact on the State Second Pension (S2P)
In 2002 the Government replaced the state earning related pension (SERPS) with the S2P. The S2P gives people who earn lower wages, or aren’t able to work as much as other people, the chance to earn a better additional State Pension.
Under the rules for the S2P, people who earn above the lower earnings limit (LEL) – (£4,940 a year in 2009/10) – but below the low earnings threshold (currently £13,500) are treated as if they had earnings at the low earnings threshold and therefore qualify for a full year’s contribution towards the S2P. Because the LEL is below the current income tax personal allowance and earning thresholds for National Insurance, is it therefore possible to qualify for the S2P without incurring a charge to tax.
As with a private pension, dividends and investment income are not earnings for the S2P, and therefore it is necessary for directors to draw a small salary (usually equal to the income tax annual personal allowance so no tax is due) before extracting remaining profits by dividend.
This is a simple but effective tax planning tool but is often overlooked.
Company contributions
A company may make an unlimited contribution to an employee’s pension scheme. However, a contribution will only be deductable against a company’s taxable profits if incurred wholly and exclusively for the purpose of the trade. Consequently, large one-off contributions which greatly exceed annual remuneration may be subject to scrutiny by the tax authorities.
[1] Including a limited liability partnership (LLP)
| |
Incorporated |
Unincorporated |
| Trading profits |
Subject to corporation tax.Corporation tax is currently 28%.Companies with profits less than £300k pa are taxable at a ‘small companies rate’, currently 21%. |
Profits are included in the sole trader/partner’s personal income tax calculation along with any personal income (such as bank interest/dividends/rental income). Trading profits are also liable to Class 4 National Insurance. |
| Trading losses |
Losses may only be used against the profits of the same company in the current or preceding year or, if the company has a group or consortium, of other members of that group or consortium. Unused loss may be carried forward but only offset against future trading income from the same trade. |
Losses may set off against the sole trader/partner’s other income or capital gains of the current tax year and/or the preceding tax year.Losses made in the first four years of a business may be set against personal income of the three preceding years taking the earlier years firstUnused loss may be carried forward but only offset against future trading income from the same trade. |
| Remuneration of business owners |
Director’s salaries are subject to income tax and National Insurance. Salaries also subject to Employers National Insurance contributions. Salaries and the ER’s NIC should be deductable against trading profits for tax purposes.Dividends received by shareholders are subject to income tax but not National Insurance. The company is not liable to EE’s NIC but is not entitled to offset the dividend payment against taxable profits.The value of any non-cash assets extracted from the company may be deemed a dividend distribution if the recipient is a shareholder but not a director, or subject to income tax if the recipient is a director. |
As any trading profits are taxed directly on the sole trader/partner at the time they are earned no further tax liability should arise on actual distribution of profits from the business. |
| Pensions |
Pension contributions by a company, whether to a personal pension of the employee or to a registered company pension plan (both within specified limits) obtain corporation tax relief in the company and are not liable to tax as benefits in the hands of the director/shareholder. Having the company make the pension contribution avoids significant National Insurance cost.Further tax saving opportunities exist within the ‘tax free’ pension zone e.g. the use of SIPP’s. |
Pension contributions are made personally by each member and are tax deductable. Personal pension contributions do not avoid National Insurance cost.Further tax saving opportunities exist within the ‘tax free’ pension zone e.g. the use of SIPP’s. |
| Finance costs |
Tax relief is available for interest paid, to the extent that it is wholly and exclusively incurred for the purposes of the trade. |
Interest incurred partly for private purposes, like hire purchase interest on a car used for both business and private use, must be apportioned. The private element is not deductable against taxable profits. |
| Disposal of business assets |
A gain on disposal of assets is subject to corporation tax. Stamp duty may also be payable on assets transferred by deed i.e. land |
A gain on disposal of assets (generally apportioned between members of a partnership in proportion to the profit-sharing ratio) is subject to capital gains tax. A reduced rate of tax may be available for certain qualifying disposals of business assets. Stamp duty may also be payable on assets transferred by deed i.e. land |
| Disposal of an interest in the business by shareholders/members |
A gain on disposal of shares by a shareholder is subject to capital gains tax. Relief may be available for certain qualifying disposals. Stamp duty is also payable at 0.5% of total consideration. |
A disposal of an interest in the business is a disposal of the underlying assets (see above) |
| Related parties |
The company is connected with a person if that person has control of it or he has control of it with persons connected with him. Also any two or more persons acting together to secure or exercise control of a company are, in relation to that company, connected with each other and with any person acting on their instructions to secure or exercise control |
Partners/members are connected persons not only with their fellow partners but also with the spouses and relatives of their partners |
| Inheritance tax |
100 per cent business property relief applies to unquoted shares in a ‘trading company’, and unquoted securities in a company which with other such securities or unquoted shares gave the transferor control immediately before the transfer. 50 per cent business property relief applies to quoted shares if they, with other shares, etc gave the transferor control immediately before the transfer. |
100 per cent business property relief applies property consisting of a ‘trading business’ or an interest in a business (which can extend even to cash or deposit holdings if they are shown to be held for business use either currently or in the near future). 50 per cent business property relief applies to property held outside a partnership |
| Problem areas |
A capital gain by a company may be chargeable twice – once to corporation tax in the company and again to income tax or capital gains tax on extraction of proceeds from the company.Income splitting through the use of companies and shares (‘husband and wife’ companies) is ineffective unless the arrangement stands up to scrutiny on an arm’s length basis or, it does not involve the ‘diversion of income’ from one individual to another, or does not give rise to an overall tax saving. |
A change in profit share ratio may trigger a part or whole disposal from one partner to another of the share in the business assets. This may or may not be a chargeable disposal and would need to be reviewed on a case by case basis. |
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