Is operating as a sole trader costing your business money?

For as long as I have been advising clients, the decision as to whether and when a business should consider incorporating has been a relatively simple one.

For some, trading as a sole trader, partnership or LLP is the most suitable choice of business structure from the outset. However, for the majority, the decision as to whether they should incorporate or not often boils down to the point at which profits reached a level whereby the potential tax savings associated with trading as a limited company are enough to outweigh the increased hassle and administrative costs.

There are two aspects to this potential tax saving. First, many clients are set up so that they take a small salary from their company at a level which incurs neither income tax nor national insurance. The rest of their income is taken as a dividend, which incurs no national insurance and, up to a certain level, incurs no income tax. Therefore, the only tax payable is corporation tax at 20 per cent.

In comparison, trading as a sole trader, partnership or LLP means profits are subject to income tax and Class 4 national insurance. This Class 4 national insurance at 9 per cent could mean that an extra £3,000 of tax would be payable by each sole trader or partner in a partnership.

The second saving is a limited company is able to shelter undrawn profits from higher rates of tax. Sole traders are simply taxed on their profits so if those profits exceed the basic rate tax threshold, some tax would be payable at 40 per cent. Conversely, all limited companies now pay corporation tax at 20 per cent regardless of their size.

Business owners taking income out of companies start to pay higher rate tax on dividends beyond the basic rate threshold, however, those who don’t need to take all of the profit out can leave cash in the business and avoid paying any higher rate tax.

For many years people have been speculating that the government would start charging national insurance on dividends. However, the surprise announcement in the July 2015 budget was that the way in which dividends are to be taxed would change from next April.

From next April, the first £5,000 of dividends will be tax free. Thereafter, dividends will be taxed at 7.5 per cent up to the basic rate threshold and 32.5 per cent above this point (additional rate tax payers will pay 38.1 per cent on dividends).

This tax increase means that in the future the decision as to whether to incorporate will not be so clear cut.

The ability to shelter undrawn profits from higher rates of tax still remains, so for those who will benefit from this, the answer may still be the same. Many others will also still be better off as a limited company as the tax on dividends will still be less than the national insurance payable as a sole trader, however, there will be those who might be worse off.

There are of course plenty of other reasons not associated with saving tax as to why it may or may not be beneficial to incorporate and businesses should seek professional advice before considering making any commitment.

Related Article: Companies that don’t pay tax UK

Simon Hayden is a partner at Perrys Chartered Accountants.

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