As we said in our previous post, running a business through a limited company usually gives you tax advantages. Below is a very simple comparison of tax liabilities between self-employment and incorporation:
Suppose Cheryl is a pop musician and her annual trading profit for the tax year 2011-12 is £30,000. Is she better off as a sole trader or limited company?
What if she is a sole trader ...
Assuming Cheryl has no other taxable income, the income tax payable on her self-employed income of £30,000 would be (£30,000 - £7,475) × 20% = £4,505.
(£7,475 is the personal allowance she is entitled to.)
As she is self-employed, she is liable for both Class 2 and Class 4 National Insurance Contributions.
Class 4 National Insurance Contributions = (£30,000 - £7,225) × 9% = £2,050.
Class 2 National Insurance Contributions are payable at a rate of £2.50 a week, which is equivalent to £130 a year.
Therefore, if she is a sole trader and earns £30,000 in the tax year, her total tax liability would be £4,505 + £2,050 + £130 = £6,685. Not too bad.
What if she is a limited company ...
If Cheryl decides to trade as a limited company, as a rule of thumb, the most tax-efficient fund extraction strategy can be achieved by paying herself a "nominal" salary from her company (equal to the National Insurance lower earnings limit).
As her "nominal" salary is tax-deductible from the company's point of view, her salary is deducted from the company profit and the company pays corporation tax on the remaining profit.
Once the corporation tax is deducted from the company profit and loss account, it will be distributed as dividend to Cheryl.
Below are the calculations:
As she receives a "nominal" salary from her company, we can deduct £7,225 from the company profit .
However, there will be a sneakily small amount of national insurance due on her salary.
Employer National Insurance Contributions = (£7,225- £7,072) × 13.8% = £21.
As national insurance is tax-deductible, the company will be paying corporation tax on £30,000 - £7,225 - £21 = £22,754.
Corporation Tax = £22,754 × 20% = £4,551.
The amount of profit which is distributed as dividend to Cheryl is therefore £30,000 - £7,225 - £21 -£4,551 = £18,203.
Remember it is the net amount of dividend she receives from her company. We need to gross it up.
Gross dividend to Cheryl = £18,203 × 100/90 = £20,226.
The difference between her gross dividend and net dividend, i.e. £2,023 is the tax credit she can deduct from her income tax liability.
Income tax is payable on her "nominal" salary - £7,225 and her gross dividend - £20,444. Remember, while the basic tax rate on salary is 20%, the basic tax rate on dividend is 10%, which is why running a limited company can save you tax. The calculation of her income tax is as follows:
Income tax on her salary = max(£7,225 - £7,475 , £0) = £0.
She uses most of her personal allowance against her "nominal" salary. As she has got £250 of personal allowance left, we can use it against her gross dividend.
Income tax on her dividend = (£20,226 - £250) × 10% = £1,998.
Therefore, the total income tax liability is £0 + £1,998 = £1,998.
However, we need to deduct the tax credit on dividend of £2,023 from her income tax liability to arrive at the amount of income tax payable.
Total income tax payable = max(£1,998 - £2,023 , 0) = £0.
There is no employee national insurance due on her "nominal" salary (as it is equal to the National Insurance lower earnings limit) and no national insurance due on her dividend either (as it is outside the scope of National Insurance).
Therefore her total tax liability (employer national insurance, corporation tax and income tax) = £21 + £4,551 + £0 = £4,572. Oh My God.
Conclusion
The tax savings as a result of running a limited company are £6,685 - £4,572 = £2,113. What a difference a limited company makes.
So as you can see, it doesn't take a "precious accountant" to help you save (and avoid) tax and you don't need to be as rich as Cheryl to get good tax advice.
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