3 Mins
Last Updated on 1 August 2022
Transferring a sole trade business to a limited company is perceived as an easy way of saving on tax and national insurance. However, various changes to rates of tax have made it necessary to undertake detailed tax cash flow comparisons before making the decision on whether or not to incorporate.
Prior to 2016 dividends could be extracted from a company and if they fell into the basic rate band the recipient did not suffer any additional tax. This changed with the reform of dividend taxation in 2016. Now, all dividends are received gross, and taxable at 8.75%, 33.75%, or 39.35%, to the extent that they fall into the basic, higher or additional rate bands. This would ensure there was a tax charge on all shareholders extracting dividends from a limited company, over the 0% band, currently £2,000. This now means that incorporating a sole trade business may not automatically produce significant tax savings.
We have illustrated the impact of a one-person sole trade incorporation and our figures are based on the director extracting a small salary and the rest in dividends
| £50,000 (profits) | £75,000 (profits) | £100,000 (profits) | |
| Net cash- Director | £39,809 | £55,235 | £68,650 |
| Net cash- sole trade | £36,962 | £50,908 | £64,846 |
| Difference in after tax cash in hand | £2,847 | £4,327 | £3,804 |
Based on a salary level of £9,100 a sole director/shareholder would have cash in hand of £39,809 compared to £36,962 as a sole trader at a profit level of £50,000 (Additional cash of £2,847). As noted above, the company structure is advantageous based on illustrative profit levels of £50,000 to £100,000.
Our illustrations have also included the corporation tax charge of 19% on the company’s profits.
Currently, there is a single rate of corporation tax of 19%. However, from April 2023, the main rate of corporation tax will increase to 25%. Companies with profits not exceeding £50,000 will continue to use the small profits rate of 19%. Companies with profits in excess of £50,000 will be charged 25%. However, where profits do not exceed £250,000, marginal relief can be deducted to reduce the effective rate of tax. Based on taxable profits of £100,000 the effective rate of tax (after marginal relief) would be 22.75%. This additional tax charge will mean that this will leave less distributable profits for the shareholder to take as dividends.
Summary
Following the corporation tax rate rise the tax benefits of incorporation are likely to decline and it is unlikely to be worth incorporating from a purely tax-motivated angle, unless it is certain the profits will remain at a level roundabout £50,000.
The sole trade may wish to incorporate to take advantage of the limited liability protection the company has to offer; however, it may also be worth considering an LLP structure, which offers flexibility in terms of profit sharing, although are taxed in the same way as partnerships where profits are taxed on an arising basis as each member’s marginal rate of tax.
It is also worth considering leaving profits within the company and these can be drawn out at a future date perhaps when the shareholder is possibly paying tax at a lower rate.
Pension contributions can also be paid by the company into the director’s pension scheme. These contributions would be deductible for corporation tax purposes. Additionally, employer contributions are not limited to your relevant earnings but do count towards your annual allowance which is currently £40,000.
If these options are not suitable, i.e., because the director shareholder needs as much money as possible from the company each year, another strategy would be to bring a spouse or civil partner in as a second director shareholder.
Firstly, assuming there is no other income, both directors would withdraw a salary, saving corporation tax of up to 25%. Secondly, the income paid out to the individuals would enjoy the benefits of two personal allowances, basic rate bands and dividend allowances.
There is certainly much to consider in terms of whether to incorporate and also how to extract cash from a limited company in the most tax-efficient manner. Should you wish to discuss your business structure and how best to extract cash we would be delighted to speak to you.
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