Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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December 2002

Q:

I make a profit of around £30,000 a year (before drawings) as a sole trader. Normally, I draw all of this for my living expenses etc. Would I save tax if I incorporated the business? And, if so, what about the higher national insurance contributions and audit fees etc?

A:

The question whether sole traders or partners should incorporate their businesses has been a 'hot' topic in recent months. Some commentators have expressed the view that the Government is actively encouraging businesses to operate as companies by making the tax system more attractive for them, compared with unincorporated businesses. An example of this is the 0% corporation tax rate for company taxable profits not exceeding £10,000, with effect from 1 April 2002.

The figures below illustrate the potential tax savings by incorporating your sole trader business. I have compared your present tax (and national insurance) position with your potential liability on salary and dividend paid through a limited company.

There are three points worth noting in particular with regard to the above comparisons:

1. Director's remuneration under the 'Company' option has been set at the level of personal allowance for 2002/03, such that no tax is payable in the example. This level of remuneration also ensures that National Insurance Contributions (NICs) are paid at a rate of 0%, which is sufficient to maintain an entitlement to state benefits. However, there are potential implications for national minimum wage (NMW) and pension purposes.
   
   There is a general requirement to pay employees the NMW (£4.20 per hour from 1 October 2002). However, directors who do not have explicit employment contracts are unlikely to fall within the NMW provisions (i.e. if there is no written employment contract or other evidence of an intention to create an employer/worker relationship with the company).
   
   A Salary (but not dividends) constitutes 'earnings' for purposes of calculating the maximum level of contributions that can be paid into a personal pension scheme (which is broadly based on a percentage of net earnings, by reference to age). However, your sole trader profits can form the basis for your pension contributions for the current and next five years. In any event, personal pension contributions of up to £3,600 per annum can be paid irrespective of the level of earnings.
   
   
2. On the issue of professional costs, accountancy fees are generally higher for limited companies than for sole traders. This is probably because of certain statutory requirements for companies (although these days there is an exemption for companies from the requirement to have company accounts audited, and this audit threshold is sufficiently high to benefit many family companies).
   
   
3. For the purposes of illustrating the potential savings by incorporating the business, most of the income extracted from the company is in the form of dividends as opposed to salary. This is because dividends are taxed at only 10% for an individual who is not a higher rate taxpayer, whereas the same taxpayer would be liable to tax at a marginal rate of 22% on salary. In addition, dividends do not attract a national insurance contributions charge, whereas employees can pay contributions at 10% up to an upper threshold (currently £30,420), whilst employers are generally liable at 11.8%, without limit. Increases in national insurance contributions (for both the employed and self-employed) taking effect from 6 April 2003 are likely to make dividends an even more attractive alternative.

In conclusion, incorporating your business can potentially save you tax and national insurance contributions. For many sole traders and partnerships, incorporation will be the right option. However, my advice is not to do so blindly, which means considering all the implications of operating your business through a limited company. As the old saying goes, "never let the tax tail wag the commercial dog".

Mark McLaughlin

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