This is an important consideration for many people considering self-employment and a question frequently asked by individuals such as Computer Contractors, IT Consultants, Management Consultants and Locum Pharmacists. The answer is “it all depends”.
Self-employment is preferred by many such individuals because it is a straightforward way to operate with limited formalities in terms of record keeping and compliance.
Using a Limited Company on the other hand involves having accounts properly prepared and filed with HMRC and Companies House along with the weight of the Companies Act 2006. One also should take into account that the Limited Company route results in higher accountancy costs.
Despite higher costs and additional compliance, the use of a Limited Company often results in a lower overall tax liability. Let us consider some examples: –
Bob is a Locum Pharmacist whose only source of income is from locum work. Suppose his profits were £40,000 for the year to 5th April 2012. His total liabilities will be as follows: –
|
Net Profit |
£40,000 |
|
|
Income Tax |
||
|
£7,475 @ 0% |
£0 |
|
|
£32,525 @ 20% |
£6,505 |
|
|
Total Tax |
£6,505 |
|
|
National Insurance (NI) |
||
|
£7,225 @ 0% |
£0 |
|
|
£32,775 @ 9% |
£2,950 |
|
|
52 weeks x £2.50 |
£130 |
|
|
Total NI |
£3,080 |
|
|
Total Tax & NI |
£9,585 |
|
|
Net Income |
£30,415 |
|
Now suppose instead Bob had started using a Limited Company from 6th April 2011 and that company makes up its first accounts to 5th April 2012. Let’s assume that because costs are higher, the profit within the company is £500 less at £39,500.
The most efficient way to use a Limited Company is to draw a low salary and distribute the profits net of corporation tax as dividends. The optimum salary level for the year to 5th April 2012 is £7,225, and a person receiving such a salary with no external income can receive up to £31,725 in dividends without paying any Income Tax personally.
|
Net Profit Before Salary |
£39,500 |
|
Net Profit After £7,225 Salary |
£32,275 |
|
Corporation Tax |
|
|
£32,275 @ 20% |
£6,455 |
|
Net Profit After Tax Paid As Dividends |
£25,820 |
|
Total Net Income Including Salary |
£33,045 |
Using optimal tax planning, Bob will enjoy a net income of £33,045.
Therefore, despite having faced extra costs, Bob’s net income is £2,630 or 8.6% higher as a result of operating through a company.
If we take a look at a second example, Jeff is an IT Contractor who generates profits of £80,000. In this situation the comparative figures are as follows: –
|
Net Profit |
£80,000 |
|
|
Income Tax |
||
|
£7,475 @ 0% |
£0 |
|
|
£35,000 @ 20% |
£7,000 |
|
|
£37,525 @ 40% |
£15,010 |
|
|
Total Tax |
£22,010 |
|
|
National Insurance (NI) |
||
|
£7,225 @ 0% |
£0 |
|
|
£35,250 @ 9% |
£3,173 |
|
|
£37,525 @ 2% |
£751 |
|
|
52 weeks x £2.50 |
£130 |
|
|
Total NI |
£4,054 |
|
|
Total Tax & NI |
£26,064 |
|
|
Net Income |
£53,936 |
|
Vs
|
Net Profit Before Salary |
£79,500 |
|
Net Profit After £7,225 Salary |
£72,275 |
|
Corporation Tax |
|
|
£72,275 @ 20% |
£14,455 |
|
Net Profit After Corporation Tax |
£57,820 |
|
Net Dividend After Income Tax |
£51,296 |
|
Total Net Income Including Salary |
£58,521 |
Again, the use of a Limited Company is advantageous, with an increase in net income of 8.5%, which due to the higher level of earnings is a greater benefit in numerical terms. Of course, this example assumes that all net profit is drawn as a dividend. One of the key benefits of a Limited Company is that unlike self-employment, the individual enjoys control over what dividend levels are declared and can, if personal expenditure permits him to do so, reduce the dividends and reduce or avoid higher rate Income Tax altogether.
Shares being held by a spouse may be an alternative tax planning opportunity for some, making use of any available basic rate tax band to avoid higher rate Income Tax.
Clients should not be afraid of retaining profit within a company, as this can be a very effective means of investing and planning for retirement. A Limited Company enjoys a wide range of investment choice to suit most requirements and attitudes to investment risk.
It has to be said that incorporation is certainly not for everyone. For example, a part time contractor or locum generating profits of £10,000 is likely to be no better off because the National Insurance savings will be swallowed up by higher costs. Similarly those who put a high value on the informality and simplicity of self-employment may consider that the tax savings are insignificant. But if your earnings are around the level of Bob, our fictional locum, or higher, and you are not put off by a little administration, take advice today!
This article has been produced for general guidance only and does not constitute tax advice. Whilst every care has been taken in its preparation, Warr & Co will not accept liability for any loss incurred as a result of any use made of this document or its contents. We will be happy to offer specific advice to clients when requested. Should you have any queries or wish to discuss any of the points raised please contact Steve Prosser or contact Tim Warr or Peter Edwards @ Warr & Co Chartered Accountants.