We previously discussed the differences between a limited company and a sole trader business in this blog. We went over the advantages and disadvantages of each to help readers decide which would be best for their business. Unfortunately new rules coming into place from HM Revenue and Customs (HMRC) have drastically changed the dynamic from a tax point of view.
What is different?
The main difference is the tax on dividends which can be found by clicking this link. This tax means company directors will have to pay additional tax, which closes the gap on whether a limited company or sole trader is better from a tax point of view.
How does this affect which method is more tax efficient?
Previously, the choice was obvious; a sole trader paid tax at the same rate as corporation tax, but only at the basic rate band, plus there was the National Insurance Contributions (NIC) adding roughly an extra 9% tax. The common way to avoid this was to pay yourself a wage to use up personal allowance (and count for NIC), then draw additional profits as a dividend using the tax credit provided to not pay any additional tax in the basic rate band.
Now, trying to do the above grants a 7.5% tax on top of the company’s 20%. This combined with the dividend allowance being £3,000 less than the NIC one gives an almost comparable overall amount of tax between limited companies and sole traders at lower levels of income.
After extensive calculations I can say that for businesses that earn less than £20,000 profit with a single director are usually better off being a sole trader business from a tax point of view in the 2016/17 tax year.
When profits go into the higher rate bracket, the higher rate of dividend tax causes the tax on the limited company method to begin to catch up to the sole trader tax amount. They overlap again at around £120,000 of profit.
Essentially, the 20% tax rate is accompanied by a 32.5% dividend tax rate. This is a total of 52.5% tax compared to self-assessment’s 42% higher rate tax and NIC.
The above statements are true for those who draw all of the profits from their business each year.
Additionally, the employer’s NIC allowance of £3,000, which effectively halves the NICs paid on behalf of employees cannot be claimed for directors after the 6th of April 2016. This means directors/owners who pay themselves above the NIC limit will be paying roughly twice as much NIC than in previous years.
Does this mean I should switch to a sole trader business?
While there is a substantial increase in the tax that company directors have to pay, there are still other factors to consider.
Limited companies give you some control over your taxes by choosing to leave profits in the company. Naturally, if you choose to only draw an amount of profit you feel you need to get by with, (normally enough to use up the basic rate band) you will save tax compared to a sole trader, who count as drawing all of the profit from their business.
Limited companies still count as separate entities, which means personal assets will be safe if someone actions a debt recovery service against your business.
Even if the dividend income counts for payments on account, a company director will have substantially lower payments on account than the sole trader business. Directors would only have payments on account for the dividend portion rather than the entire tax amount.
If a limited company has a different year end than the tax year, overall tax can be split across the year. This would be done with paying the corporation tax element at one point and the self-assessment element at another time.
Conversely, limited companies still require more time and effort to complete accounts and tax returns. Where the tax for both methods looks similar, taking additional accountants fees into account could show limited companies to be more expensive than any savings made from a tax point of view.
In summary, for those of you who use their limited companies to draw enough profits to stay in the basic tax rate band, you will have to pay additional tax. However you will still be running the more tax-efficient option, while still getting the benefits of a limited company.
For more information regarding the above, please do not hesitate to contact us.