The choice of a suitable business medium, for example, sole trader,
partnership or limited company may have a substantial impact on the
level of reliefs, allowances and tax levied on you and your business.
l iabilities. The briefing also introduces the issues which impact on changing your business structure from unincorporated to a company.
Throughout this section it is assumed that the individual or company
has no other income or profit chargeable to tax and that no other
expenditure or relief is available to relieve tax charges.
Unincorporated business
The taxable trading profits of a business run by an individual as a sole trader
are taxed directly on the owner, irrespective of whether the owner draws the
money from the business for personal use. The same applies to the profit share
of a general partner in a partnership (including a member of a Limited Liability
Partnership). The principle applies for both income tax and NIC.
Currently this means that a sole trader or partner whose taxable profit does not
exceed £100,000 will be charged to income tax as follows:
- the first £6,475 is tax free due to the availability of the personal allowance
- the next £37,400 is charged at 20%
- any further profits are charged at 40%.
Where taxable profits exceed £100,000 additional rules impact which increase
the tax charge.
If overall income (less certain reliefs) is in the range £100,000 to £112,950 the
personal allowance of £6,475 is reduced by £1 for every £2 in excess of £100,000
so that there is no tax-free allowance once income reaches £112,950.
In addition, the higher rate tax of 40% only applies until profits reach £150,000
then the excess profits are taxed at an additional rate of 50%.
The position for NIC is more straightforward. All self-employed earners who
expect profits in excess of £5,075 are liable to pay Class 2 of £2.40 per week.
This is usually settled by direct debit monthly. In addition, Class 4 is paid on
taxable trading profits as follows:
- the first £5,715 is NIC free
- the next £38,160 is charged at 8% and
- any excess is charged at 1%
Tax tip
A business starts initially as a sole trader but later a legal partnership is formed
with the spouse sharing profits equally. Tax savings may result depending on the
precise circumstances. For example, where the spouse was not previously
employed by the business and had no other income, a net overall tax saving of
£3,723 could be achieved if the original sole trader business currently had
profits of £60,000. This saving assumes that both spouses would be subject to
Class 2 and 4 NIC.
The incorporated business
When the trade is carried out in a company, the company not the individual initially
suffers the direct tax charge on the taxable profit. The rate depends on the level of
profit but all corporation tax (CT) rates are lower than the personal higher and
additional rates of tax. The effective rate of tax for a company not associated
with any other company is
- 21% for the first £300,000
- 29.75% for the balance provided profits do not exceed £1.5 million and
- 28% flat rate for companies with profits in excess of £1.5 million.
What does this mean for the individual as owner?
The owners who are generally both shareholders and directors only suffer tax
and NIC on any profits extracted from the company, so any profits retained in the
company are sheltered from personal tax rates.
There are a number of different methods of extracting profits but again tax rates
and NIC may need to be considered to minimise liabilities. Currently, significantly
lower tax liabilities can arise on capital gains compared to income extraction but
this is generally only available in limited circumstances such as when the
individual sells their shares or the company is liquidated. In the meantime,
director/shareholders will need to extract income for personal living and this has
a tax and in some cases a NIC cost.
The two common methods used are remuneration and dividend. Tax relief is
generally available for director/employee remuneration including NIC costs but
not for dividends.
Remuneration
Any form of cash remuneration (salary, bonus, fees) and taxable benefits
(medical insurance, car etc) are taxed as employment income attracting the
normal income tax rates as outlined earlier. In addition employed income
(excluding benefits) attracts Class 1 NIC for both the individual and the
employing company. This is 11% for the individual on any income in excess
of £5,715 up to a limit of £43,875, then 1% on any excess.
The employer is liable for 12.8% Class 1 on all earnings in excess of £5,715
with no upper limit and although employees are not liable to NIC on benefits,
generally Class 1A NIC is due from the employer at the same 12.8% rate.
Dividend
When a dividend is paid to an individual it is subject to different tax rate
compared to other income. The rates (as applied to gross income are):
- Basic rate taxpayers 10%
- Higher rate taxpayers 32.5%
- Additional rate taxpayers 42.5%
The overall tax cost effect on the company and the individual of comparing the
extraction of a dividend with remuneration as a bonus is as follows:
Example
Simon wishes to extract £30,000 after all tax costs from his owner managed
company to pay for his daughter’s wedding. He is a 40% taxpayer and due to his
existing company salary any NIC cost would be 1% only. The cost to the compan
of paying a dividend is £40,000 irrespective of the company’s own tax rate. The
respective net tax cost for the company of voting a bonus would range between
£40,292 - £45,311 depending on whether the corporation tax relief on the bonus
and related NIC was at a rate of 21/28/29.75%.
Dividends are often used in combination with remuneration to obtain the most
tax effective extraction of profits when the business is carried on through a
company but how does this compare with the sole trader or partner generating
taxable profits in an unincorporated business?
profit and compare his position with Gordon who runs a similar business
through a company and who has also made a £60,000 profit before any
director’s remuneration. Gordon has decided to take out a salary of only
£5,715 because this means he will get an appropriate NIC credit for certain
state benefits including state pension without an NIC charge. There is also no
income tax as it is below the personal allowance. The rest of the profit after
corporation tax is deducted will be extracted as a dividend. The overall tax and
NIC saving of incorporation at this level of profit for 2010/11 would be £3,734
Whilst this shows that tax savings can be achieved by carrying on a business
through a company, tax should not be the only factor considered before
incorporating a business.
that the reliefs available to relieve any trading losses are generally
more comprehensive and flexible than the equivalent available to a
new company.
The idea is that losses are more likely in the early stages of business
development so early and effective use not only saves tax but is cashflow
beneficial.
Example
A new trader incurs modest losses of £15,000 in each of his first two years. He
has no other current income as he is investing his savings in the new business.
However, prior to starting the business he was in employment and in the previous
three years had earned around £60,000 each year.
Under income tax loss relief provisions, he will be able to relieve both losses
against previous income on which he suffered 40% tax obtaining a refund of
£
12,000 which will be a useful additional injection into the new business.
If he had started this new business as a company the combined £30,000 loss
would only be available for carry forward against future trading profits as they arise.
The recent recession has also demonstrated that losses can hit an established
business. In this situation many traders and companies are able to relieve
losses against previous profits and obtain refunds subject to certain conditions.
This is also the case generally where a tax loss is created even though the
business is profitable. This can occur if a business incurs significant plant and
machinery expenditure due to the availability of tax relief. The Annual Investment
Allowance on qualifying expenditure (not cars) currently provides 100% relief on
up to £100,000 annually (limited to £50,000 before April 2010).
you are planning new investment in plant so that we can assist you to maximise
your opportunities.
certain disposals is Entrepreneur’s Relief (ER).
This is available to reduce gains of up to £2 million (£1 million before 5 April 2010)
on a qualifying material business disposal and applies to both unincorporated
business interests and company shares. The impact of the relief is that it reduces
the effective rate of capital gains tax from 18% to 10%. A property personally owned
but used in a trading partnership or company may also qualify. Detailed conditions
apply and it is important to plan at least 12 months ahead to secure the relief
effectively. For example an individual with trading company shares must have
held 5% and be an officer/employee for the 12 months leading to the disposal.
To achieve effective capital extraction detailed conditions must be met. The CGT
rate may also change following the Budget on 22 June 2010 so contact us for
further information.
generally available at a rate of 100% for both unincorporated
b usiness interests and unquoted company shares on lifetime gifts
and at death.
This generally saves IHT at 40%. Where a trading property is not held on the
balance sheet of a partnership or a company as it is personally held outside the
business, this will only qualify for 50% BPR at most. Further in relation to a
property used in your trading company there is a risk of no BPR being available
unless you have and retain control of the company’s voting power.
If circumstances induce you to incorporate your existing unincorporated
business to obtain income tax and NIC savings, there will be a number
of factors for you to consider.
Key non tax factors include being aware of the legal and accounting formalities
of operating a company which usually result in higher professional fees and
ensuring that practical matters of the transfer are considered, for example, new
business stationery and informing customers, suppliers and the authorities like
HMRC and even the DVLA!
Incorporation means the trade ceases for income tax and a new trade starts
in the company. This may lead to profit distortions in the final period if careful
planning is not considered. It also often involves the disposal of assets to the
company which impacts upon both capital allowances and capital gains.
Properties are often retained in personal ownership. This is generally done to
minimise the overall tax charges on a future disposal (of the property) as
corporation tax would arise on any gains and also personal tax on extracting the
rest of the profit. It also avoids Stamp Duty Land Tax which would apply on the
transfer. Gains can also arise on the transfer of goodwill.
Gains which do arise may be reduced to a 10% effective rate of tax using ER
whilst the capital gains tax rate remains at 18%.
Planning is needed in particular to
- Maximise the capital allowance position for your circumstances
- Minimise the impact of tax liabilities including IT, NIC and CGT
- Consider the cash flow impact of the timing of any tax payments
on changeover - Obtain valuations of assets particularly the goodwill of the business
- Ensure CGT reliefs are maximised
Once in a company structure any decision to transfer back to being an
unincorporated business is also a trade cessation with a disposal of
chargeable assets. The critical difference is that there are fewer reliefs available
for such a ‘disincorporation to ensure the process is tax efficient. This
emphasises the point that long-term considerations should be taken into
account as well as short-term tax advantages in choosing and changing
business structure.
Many of the issues contained in this briefing have detailed rules which must be
properly considered to achieve the desired outcome, so please contact us to
r
eview the areas suitable for your specific aims.
Disclaimer - for information of users - This briefing is published for the information of clients.
It provides only an overview of the regulations in force at the date of publication, and no action
should be taken without consulting the detailed legislation or seeking professional advice.
Therefore no responsibility for loss occasioned by any person acting or refraining from action
as a result of the material contained in this briefing can be accepted by the authors or the firm.