One of the first decisions a start-up business must make is what business format to trade under. There are three basic formats sole trader, limited company or partnership, although there are some other alternatives.
The decision which format to choose has been made more complicated by a change in the way dividends from limited companies are taxed. The change took effect on 6 April 2016. Until then most people forming limited companies paid themselves a salary to use up their personal tax allowance and took the renaming profits as dividends. This was because previously dividends were treated as 10% tax paid as well as not making the recipient liable to National Insurance.
So what are the changes?
From 6 April 2016 dividends received attract tax above a Dividend Tax-free Allowance of £5,000. Above this level dividends will be taxed at 7.5% for standard rate taxpayers. Higher rate taxpayers will pay tax at 32.5% above earnings of £32,000. For the top rate of tax (earnings above £150,000) dividends will be taxed at 38.1%
How does this work in practice?
Two illustrations will help understand.
Sole Trader Tax & NIC – £5, 920
Limited Company Corporation Tax & Income tax on Dividends – £5120
Saving for limited company – £800
Sole Trader Tax & NIC – £23,128
Limited Company Corporation Tax & Income tax on Dividends – £21,470
Saving for limited company -£1,658
Figures for limited company assume a salary of £8,000 to the owner to reduce taxable profits and to minimise the NIC contributions and the balance of profits after tax paid as a dividend to the owner
With profits of £30,000, a saving of £800 for the limited company would be absorbed by the additional costs of administration of a company.
So from 2016/17 onwards to make savings in taxation, choosing a limited company is now less tax-efficient. To cover the costs of being a limited company and to make significant savings in taxation, a business needs to be making profits approaching £40,000. The savings of forming a limited company start tailing off at around £50,000 and at £100,000 the tax saving will probably not justify the additional costs.
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Help for businesses can be obtained from ICAEW’s Business Advice Service. This is a free straightforward discussion with an ICAEW Chartered Accountant. Further information can be found at www.businessadviceservice.com
Article by Clive Lewis, ICAEW in conjunction with X-Forces.