According to a new survey carried out by Alliance & where ID_NUM=9270;

Leicester, one in five small business owners view tax as

their greatest concern. The Chancellor has announced in his

last budget that companies with profits below œ10,000 will

not have to pay any corporation tax with effect from 1 April

2002. The question to be asked is: does that announcement

make incorporation a more attractive option compared to

being a sole trader?

The answer is that from a tax point of view, it is

advantageous to trade through a limited company as long

as the income is drawn from the company by the owners as

dividends from their shares and the amount of dividends

drawn is restricted below the 40% band rate (i.e. œ31,063

for tax year 2002/03). That way, the owners have no further

personal tax ("income tax") to pay. Moreover, dividends are

not subject to national insurance contributions. This is

excellent news of course. But, if dividend income falls

within the higher rate bracket of income tax (i.e. above

œ34,515), they will be taxed at 22.5% on the excess, which

of course will increase the tax burden. The company profits

are subject to corporation tax rates. Those are lower than

income tax rates.

The most catastrophic scenario is when the director takes

his reward from the company as salary. Then his/her salary

is taxed at income tax rates (like a sole trader's income).

That is because, unlike sole traders, the tax system treats

companies as separate from their owners because a company is

a separate legal entity. The problem is that the income

taxes are higher than corporation tax rates. On top of

that, they will be subject to employee and employer national

insurance contributions, which of course increase the tax

burden and render his position worse than even an

unincorporated business ("sole trader"), because NIC Class 1

on payroll are higher than NIC Class 2 paid by self

employed.

In contrast, a self employed person ("sole trader") is taxed

at income tax rates on the profits from his business, which

are added to his other sources of income. As it has already

been mentioned, income tax rates are overall higher than

corporation tax rates. On top of income tax, national

insurance contributions class 4 are payable on the business

profits within a specified band (7% on profits between

œ4,615and œ30,420). National insurance contributions Class 2

are also paid by self-employed people, although those are

lower than those payable by company directors on their

salaries.

To illustrate the above, let's take a simple example. We

have a limited company and a sole trader. They both make

œ60,000 profits each in the tax year 2002/03. We assume that

the company director takes a salary equal to the amount of

his personal allowances (untaxed income) of œ4,615 and the

balance as dividends. The company will pay corporation tax

at 19% equal to œ10,523 and nothing else. The sole trader

will pay income tax œ16,542, National insurance Class 2 œ104

and National insurance Class 4 œ1,806. Total œ18,452. The

bottom line is that the person that has incorporated his

business into a limited company will make a tax saving of

œ7,929 compared to a sole trader! Isn't that fantastic?

Somebody might be wondering: why is this entire happening?

The official explanation is that, this government, to help

the economy grow, encourages people to leave as much profits

within their businesses to be reinvested, instead of being

taken out and spent.

The "unofficial line" is that, as a matter of fact, for

years the Inland Revenue has tried to reclassify the

self-employed. The 1% in NIC hike on staff salaries above

the NIC threshold from next April adds to both the

employees' and employers' tax burden and may more than

offset the saving from the corporation tax zero rate on the

first œ10,000 of profits.

Aren't there any other matters to consider in deciding

whether to incorporate or not?

Higher administration costs to comply with company law,

payroll and bookkeeping is one factor. Another issue is

pension planning. Extracting profits out of the company as

dividends rather than salary means that there will be no

"net relevant earnings" and therefore pension contributions

can't be made. But the advent of stakeholder pension plans

has meant that contributions up to œ3,600 per year can be

made without the need for any earnings. If a person does not

wish to transfer funds in existing plans into stakeholder

because of high charges, there is a way out: the best net

relevant earnings (i.e. salary) in five consecutive years

can be used for making contributions for the next five

years, even if there were no salaries in the remainder four

years. It is comforting to know that entitlement to basic

state pension is not affected by taking a salary from the

company at the level of a person's personal allowances i.e.

œ4,615.

Furthermore, an individual may decide not to bother with

pension plans and instead invest in ISA. Often, these can be

more efficient than pensions but that's beside the scope of

this article. If that option is taken, no salary is

necessary.

Another factor is business motoring. It might be tax

advantageous for an unincorporated business that owns many

cars not to incorporate because if these cars have some

private use there will be benefits in kind taxed on the

users. These are generally higher than the straight

apportionment between private and business for all car

running costs in the case of sole traders.

The conclusion is that there can be considerable tax savings

waiting the sole trader who decides to go down the

road to incorporation. But, one needs to proceed with

caution and careful planning. And don't forget the biggest

advantage of incorporation, which is Protection

from Personal Liability. Incorporating is one of the best

ways to protect a business owner from personal liability.

Shareholders of a company are generally not liable for the

obligations of the company. Creditors of a company may seek

payment from its assets, but not the assets of the

shareholders. This means that business owners may engage in

business without risking their homes or other personal

property.

Thank you for taking the time to read this Article. I hope

you've found it useful. If you have, please drop me an email

and let me know what you think.

You can email me at...

constantinesavva@accamail.com

Alternatively, you can visit our website at

http://www.tax-accounting-london.info and read a series of

other full length articles that present the complete picture

on a variety of interesting topics.

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