Author: Jennifer Johnson
Source: articleage.com
According to a new survey carried out by Alliance & whereID_NUM=9270; Leicester, one in five small business owners viewtax as their greatest concern. The Chancellor has announced inhis last budget that companies with profits below œ10,000will not have to pay any corporation tax with effect from 1April 2002. The question to be asked is: does that announcementmake incorporation a more attractive option compared to being asole trader?The answer is that from a tax point of view, it is advantageousto trade through a limited company as long as the income isdrawn from the company by the owners as dividends from theirshares and the amount of dividends drawn is restricted below the40% band rate (i.e. œ31,063 for tax year 2002/03). Thatway, the owners have no further personal tax ("income tax") topay. Moreover, dividends are not subject to national insurancecontributions. This is excellent news of course. But, ifdividend income falls within the higher rate bracket of incometax (i.e. above œ34,515), they will be taxed at 22.5% onthe excess, which of course will increase the tax burden. Thecompany profits are subject to corporation tax rates. Those arelower than income tax rates.The most catastrophic scenario is when the director takes hisreward from the company as salary. Then his/her salary is taxedat income tax rates (like a sole trader's income). That isbecause, unlike sole traders, the tax system treats companies asseparate from their owners because a company is a separate legalentity. The problem is that the income taxes are higher thancorporation tax rates. On top of that, they will be subject toemployee and employer national insurance contributions, which ofcourse increase the tax burden and render his position worsethan even an unincorporated business ("sole trader"), becauseNIC Class 1 on payroll are higher than NIC Class 2 paid by selfemployed.In contrast, a self employed person ("sole trader") is taxed atincome tax rates on the profits from his business, which areadded to his other sources of income. As it has already beenmentioned, income tax rates are overall higher than corporationtax rates. On top of income tax, national insurancecontributions class 4 are payable on the business profits withina specified band (7% on profits between œ4,615andœ30,420). National insurance contributions Class 2 are alsopaid by self-employed people, although those are lower thanthose payable by company directors on their salaries.To illustrate the above, let's take a simple example. We have alimited company and a sole trader. They both make œ60,000profits each in the tax year 2002/03. We assume that the companydirector takes a salary equal to the amount of his personalallowances (untaxed income) of œ4,615 and the balance asdividends. The company will pay corporation tax at 19% equal toœ10,523 and nothing else. The sole trader will pay incometax œ16,542, National insurance Class 2 œ104 andNational insurance Class 4 œ1,806. Total œ18,452. Thebottom line is that the person that has incorporated hisbusiness into a limited company will make a tax saving ofœ7,929 compared to a sole trader! Isn't that fantastic?Somebody might be wondering: why is this entire happening? Theofficial explanation is that, this government, to help theeconomy grow, encourages people to leave as much profits withintheir businesses to be reinvested, instead of being taken outand spent.The "unofficial line" is that, as a matter of fact, for yearsthe Inland Revenue has tried to reclassify the self-employed.The 1% in NIC hike on staff salaries above the NIC thresholdfrom next April adds to both the employees' and employers' taxburden and may more than offset the saving from the corporationtax zero rate on the first œ10,000 of profits.Aren't there any other matters to consider in deciding whetherto incorporate or not?Higher administration costs to comply with company law, payrolland bookkeeping is one factor. Another issue is pensionplanning. Extracting profits out of the company as dividendsrather than salary means that there will be no "net relevantearnings" and therefore pension contributions can't be made. Butthe advent of stakeholder pension plans has meant thatcontributions up to œ3,600 per year can be made without theneed for any earnings. If a person does not wish to transferfunds in existing plans into stakeholder because of highcharges, there is a way out: the best net relevant earnings(i.e. salary) in five consecutive years can be used for makingcontributions for the next five years, even if there were nosalaries in the remainder four years. It is comforting to knowthat entitlement to basic state pension is not affected bytaking a salary from the company at the level of a person'spersonal allowances i.e. œ4,615.Furthermore, an individual may decide not to bother with pensionplans and instead invest in ISA. Often, these can be moreefficient than pensions but that's beside the scope of thisarticle. If that option is taken, no salary is necessary.Another factor is business motoring. It might be taxadvantageous for an unincorporated business that owns many carsnot to incorporate because if these cars have some private usethere will be benefits in kind taxed on the users. These aregenerally higher than the straight apportionment between privateand business for all car running costs in the case of soletraders.The conclusion is that there can be considerable tax savingswaiting the sole trader who decides to go down the road toincorporation. But, one needs to proceed with caution andcareful planning. And don't forget the biggest advantage ofincorporation, which is Protection from Personal Liability.Incorporating is one of the best ways to protect a businessowner from personal liability. Shareholders of a company aregenerally not liable for the obligations of the company.Creditors of a company may seek payment from its assets, but notthe assets of the shareholders. This means that business ownersmay engage in business without risking their homes or otherpersonal property.Thank you for taking the time to read this Article. I hopeyou've found it useful. If you have, please drop me an email andlet me know what you think. You can email me at...constantinesavva@accamail.comAlternatively, you can visit our website athttp://www.tax-accounting-london.info and read a series of otherfull length articles that present the complete picture on avariety of interesting topics.If you would like to know how to save tax and make sure thatmore of your hard earned cash stays with you to expand yourbusiness and increase your profits, we have a Free SpecialReport addressed to small businesses either starting up oralready in business. This Exclusive Free Special Report isavailable automatically when you subscribe to our regular seriesof Free Newsletters on finance advice and tax planning byvisiting our subscription area on our websitewww.tax-accounting- london.info. It is complied from real lifesituations dealing with small business tax affairs for over 10years and it is loaded with down-to-earth advice and practical,understandable examples.LEGAL NOTICE Whilst every care has been taken in the preparationof this article, the author cannot accept responsibility for anyerrors or omissions. Proper professional advice should be takenat all times.We retain copyright for the contents of this article. Anyunauthorized copying or onward distributions are prohibitedwithout our consent.
