Incorporation is the process of converting an existing sole trader or partnership business to a limited company. It can also be used to describe an existing partnership converting to a Limited Liability Partnership (an LLP). However, this is a rarer process as LLPs tend to be more suitable for professional firms with a large number of partners, such as solicitors and accountants. The rest of this information sheet is devoted to limited companies as LLPs are treated differently for tax purposes.
Many businesses start life as limited companies and never know the joys of being a sole trader or a partnership. However, for those firms that do not begin life as companies, incorporation can be a major step in their development and generally only happens after the business has established itself and the proprietor or partners have given the matter a great deal of thought. Running a limited company generally requires a higher level of administration and there are certain statutory duties and obligations, so it is not something to be treated lightly.
Most people are aware that you can save tax by working through a limited company but few imagine just how much it can amount to. The following table will give you some idea of the tax and NI savings that can be achieved each year at different profit levels.
These figures are based on rates and allowances for the 2014/15 tax year and assume a notional salary of £10,600 with the remaining post-tax profits taken as dividends. The saving is achieved mainly because a) there is no National Insurance on dividends and b) there is no tax to pay on them by the shareholder unless his/her taxable income exceeds the higher rate threshold. There is usually only corporation tax to pay at the small profits rate of 20%.
However, these savings will be greatly diminished for 2016/17 onwards due to the forthcoming changes in dividend taxation. All taxpayers will be given a £5,000 dividend allowance in place of the tax credit (which is being abolished) and above that the following rates will apply.
|Basic rate taxpayers
|Higher rate taxpayers
|Additional rate taxpayers
Assuming Class 1 NI kicks in at £157 per week, Class 2 stays at £2.80 per week and Class 4 is payable on sole trader profits above £8,164 per annum, the net income figures for 2016/17 will be as follows:
|Profit before tax & NI
|Net income as sole trader
|Net income as company
|Tax & NI saved
You will notice that the tax savings are now much lower than before. Also, they now start to actually decrease once profits exceed £50,432 whereas previously they simply tailed off. That’s because the new 32.5% rate starts to kick in on dividends once you reach this point.
However, you can avoid this by retaining profits within the company. You may eventually be able to extract these profits on the sale/disposal of the business and pay just 10% tax on them by claiming Entrepreneurs Relief, so retaining profits does not necessarily mean that you are merely delaying the extra tax that you would had to paid now.
Even greater savings can be achieved by splitting the shares with your spouse (or civil partner). As there is no capital gains tax on assets transferred between spouses, the dividends can be shared in a way that minimises your joint tax liabilities, even if one spouse contributes much more to the business than the other. However, you must do this right otherwise you may fall foul of the notorious settlements legislation.
Incorporating a business used to yield even greater tax savings until 2nd December 2014 as it was possible to claim tax relief on the goodwill in the business. Goodwill is the value of a business over and above the net assets sold to the purchaser. It represents the intangible value of the business, such as its local reputation, the skills and knowledge of its staff and its potential for future growth.
Unfortunately, these savings were torpedoed with immediate effect in the Autumn Statement that day, as Entrepreneurs Relief can no longer be claimed on goodwill sold to a connected company. The most you can claim now is your annual Capital Gains Tax allowance.
They also stopped such companies claiming annual write-downs of goodwill against corporation tax, a measure that is soon to be extended to all companies buying a business, whether connected or not.
Nonetheless, there remain significant tax advantages to working through your own company, including some we haven’t even mentioned yet. For example, you may be able to claim childcare vouchers from your company as a tax-free benefit-in-kind.
Creating a limited company is not just about saving tax, however, important though that is. You must consider all the other pros and cons too. Limited liability itself is an important factor, although the benefits are often exaggerated for small companies as banks and suppliers will usually ask for personal guarantees from the directors. It may well be critical though if the business is exposed to potential legal claims and has substantial assets such as property, which could be held outside the company.
Please give us a call if you are interested in incorporating your business and need some help with the valuation and the process.