In spite of the Chancellor’s efforts to persuade us otherwise, the 2009 Budget, when it finally came, gave scant comfort to SME owners hoping to reduce their tax bills. Instead, its "tax the rich" theme included the abolition of the £6,475 personal allowance for those earning more than £100,000 a year (reducing at a rate of £1 for every £2 over £100,000, tapering down to zero), a 50 per cent tax rate for earners over £150,000 and the phasing out of higher-rate pension relief; measures which will be effective from April 2010.
As a result of these potentially increased tax bills, one question taxpayers who are sole traders or in partnership should be asking is whether they would be better off incorporating their business as a limited company.
Incorporation, whilst slightly more bureaucratic, does give a certain amount of additional flexibility for owner managers because it allows you to manage the way you withdraw profits from the company – allowing you to take a salary, pay yourself dividends, or take money out as a loan. This will therefore give you the opportunity to manage the level of income you receive from the company and thus fall outside the new 50% rate of tax if you choose to do so.
In contrast, sole traders and partners simply receive and are taxed on their profits irrespective of the level of their drawings and thus are not in a position to manage their effective rate of tax. So how can you evaluate whether or not to incorporate Using a working example, if we compare a sole trader with a limited company, based on profits of £200,000, we can see the future difference these tax changes will make.
The sole trader will be taxed on the total amount of profits i.e. £200,000. Anything over the new limit of 150,000 (£50,000) will be taxed at 50 per cent. A further £112,600 will be taxed at 40 per cent and £37,400 will be taxed at 20 per cent. Total tax payments are £77,520, which, when added to £4,614.05 NIC means a total liability of £82,134.05 and a net income of £117,866.
Compare this with a limited company where for example the individual has the ability to limit their personal income to £150,000. Assume a minimal amount – £10,000 – is taken as salary, which after the payment of NIC, means that £189,452 is left in the company and is taxable as profit. Corporation tax of 22 per cent (assuming this increased rate is introduced from 2010), is payable on the profits giving a corporation tax liability of £41,679. The 10,000 personal income, after tax and NIC provides a net salary of £8,824. The individual could then take a dividend of £126,000 (gross equivalent of £140,000) from the company which will give a total gross income of £150,000, on which additional tax of £23,878.13 is payable.
This provides the individual with a total net income of £110,946; total tax of £65,871 and profits retained in the company of £21,772.
As you will see this is a significant tax saving with only a small drop in net income which could be ‘topped up’ from the retained profits if required.
There are also benefits in terms of flexibility and choice.
For example: is it worth taking more money out of the company this year before the increase in the rate of tax”
Furthermore on an ongoing basis if you are trading through a limited company, it would be possible to take out £149,999; leave the remainder of the money in the company and then withdraw this as a loan. Doing this means you can potentially choose whether to be taxed at the higher rate as opposed to being faced with a non negotiable, higher rate tax charge as a sole trader.
Other tax issues that SME owners need to face up to are the changes to pension contribution limits. If you earn over £150,000 and contribute more than £20,000 to pension schemes, you will be affected because tax relief on pension contributions will be restricted to the basic rate for individuals with income over £180,000 from 6 April 2011 and relief will be tapered for those with income over £150,000.
Between now and then draconian rules will apply to prevent a rush to make unusually large pension contributions in the next two years.
These rules introduce a special annual allowance, set at £20,000, which mean that tax relief on contributions above this amount will be restricted to the basic rate of tax through the use of a special annual allowance charge equal to the difference between the highest rate of income tax and the basic rate (currently 20 per cent).
To find out more about the possible benefits of incorporation, email Paul Webb at firstname.lastname@example.org.
Paul Webb is tax partner at small business specialists, Robert James.