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Cheryl Sacks MEng Oxon CTA provides a 10 point Guide to Tax choices for owner managed businesses.

Introduction

'Thou shalt pay the right amount of tax at the right time.' Right?

Yes, but as an owner manager, you can choose which taxes to pay, how much, who pays them, and even when.

This Guide is written for owner managed businesses. It aims to set out the tax treatments for your choice of unincorporated business, or incorporated business (company), and for your further choice of extracting salary or dividends from a company. For assistance with specific calculations, the author refers you to finansol.co.uk.

2009/2010 tax rates and allowances are used except where otherwise indicated.

This Guide provides only basic information on the main choices. Professional advice should always be taken based on specific circumstances.

10 Key Points

Unincorporated business

1. Overview of taxes payable

As a self employed trader or partner, you basically pay Income Tax, Class 2 and Class 4 National Insurance Contributions (NICs) on your profits, regardless of whether you leave the profits in the business or withdraw them.

2. Income tax

You may choose the annual accounting date for your business. The tax year runs from 6 April to 5 April in the following year, e.g., 2009/2010 runs from 6 April 2009 to 5 April 2010. Income tax for a tax year is usually charged on the taxable profits of the accounting year ending in that tax year. There are special rules for the opening years, cessation and if the accounting date is changed.

Your total income includes your self employment income, and may include other income e.g., from employment, property, savings and dividends. Total income may be reduced by reliefs such as pension contributions or interest on a qualifying loan, and allowances. The Personal Allowance is available to a UK resident. The allowance is £6,475 for an individual who is not yet 65 at 6 April 2010.

Your Income Tax liability is calculated on your taxable income, that is total income, less reliefs and allowances. Your Income Tax liability may be reduced by 'tax reducers', e.g., Married Couple's Allowance. This Guide does not attempt to detail the calculations. You pay 20% 'basic rate' tax on the first £37,400 of your taxable income, and 40% 'higher rate' on that exceeding £37,400. (But see 7.2 below for dividends).

From April 2010 there will be an additional 50% higher rate Income Tax 'band', on taxable income exceeding £150,000.

HM Revenue & Customs (HMRC) will calculate your Income Tax liability automatically if you file your Self Assessment Return online, or if you file a paper return by 31 October following the end of the tax year.

You pay Income Tax by two half-yearly payments on account, on 31 January in the tax year, and 31 July following the end of the tax year. The payments on account are based on your Income Tax for the previous tax year. The balancing payment, plus the first payment on account for the following tax year, is payable on 31 January following the end of the tax year.

3. National Insurance

Class 2 and Class 4 NICs are payable if you are self employed, over 16, and below pensionable age.
 
Class 2 NICs of £2.40 per week are payable if you earn more than £5,075 pa. Payment is by monthly direct debit or quarterly in arrears.

Class 4 NICs are payable at 8% on profits from £5,715 to £43,875, and at 1% on profits exceeding £43,875. Contributions are collected with Income Tax, under Self Assessment. This means that, like Income Tax, you make two payments on account, and a balancing adjustment on 31 January following the end of the tax year.

From April 2011 the Class 4 NIC rates will increase to 8.5% and 1.5%.

Incorporated business (company)

4. Overview of taxes payable

Your company may pay you a salary for working in the company as a director or employee. As the controlling director of your own company, you can decide how much salary to pay yourself. As a shareholder, you can choose a dividend to reward yourself for your investment (shares) in the company, and how much to retain in the company. The dividend is limited however, by company law, to 'distributable profits'. Taxes will depend on how much you withdraw, and in what combination.

• You pay Income Tax on your salary or dividends.
• You pay Class 1 Employees' NICs, and your company pays Class 1 Employers' NICs, on your salary.
• Fortunately no National Insurance is payable on a dividend.
• You deduct your salary and Class 1 Employers' NICs when calculating the company's 'profits chargeable to Corporation Tax'. You cannot deduct dividends.
• The company pays Corporation Tax on its 'profits chargeable to Corporation Tax'.

5. Salary: Income Tax

As described at point 2 above, your Income Tax liability is calculated on your taxable income, that is total income less reliefs and allowances. Your total income will include any salary and any dividend that you take from your company. The salary often utilises the Personal Allowance. The tax on the salary is calculated first. There is a 'basic rate band' of £37,400. Taxable salary covered by the basic rate band is taxed at 20%. Taxable salary exceeding £37,400 is taxed at the 40% higher rate, as above.

From April 2010 there will be an additional 50% higher rate band on taxable income exceeding £150,000.

Income tax on your salary is paid monthly under PAYE (see point 7 below).

6. Salary: National Insurance

All employees and their employers pay Class 1 NICs on employee earnings. Class 1 Employees' (primary) NICs are payable by the employee, and Employers' (secondary) NICs are payable by the employer.

Class 1 Employees' NICs are charged at 11% on earnings from £5,715 to £43,875 pa, and at 1% on earnings exceeding £43,875.

Class 1 Employers' NICs are charged at 12.8% on all earnings over £5,715 pa. There is no upper limit to this 12.8% rate.

As a company director, NIC is usually calculated based on your cumulative earnings in a tax year so, unlike normal employees, it doesn't matter if your salary fluctuates during the year.

From April 2011 all Class 1 NIC rates will increase by 0.5%, i.e., the above rates will increase to 11.5%, 1.5% and 13.3%.

NICs on your salary are usually paid monthly under PAYE (see point 7 below).

7. PAYE

PAYE (Pay As You Earn) is the system you use for deducting, and paying to HMRC, Income Tax and NICs on employment income.

Basically, your employment earnings will be treated as being paid on the date the payment is actually made, or for a director, the date on which your remuneration is credited in the company's records, if earlier. This determines the tax month for which Income Tax and NICs are to be deducted and paid.

The total Income Tax, Class 1 Employees' NICs and Class 1 Employers' NICs deducted each tax month (ending on the 5th) is payable within 14 days of the end of the tax month (i.e., by the 19th). If the average monthly liability is less than £1,500, you may instead pay quarterly.

8. Dividend: Income Tax

Dividends are treated as your 'top slice' of income. This means Income Tax on the dividend is calculated after calculating tax first on any salary, then on any other savings income. All, some, or none of the basic rate band may still be available. Dividend income covered by the basic rate band is taxed at 10%. The remainder of the dividend is taxed at a 32.5% higher rate.

From April 2010, where taxable income exceeds £150,000, all or part of a dividend may be taxed at an additional 42.5% higher rate.

The amount taxed is the net dividend received plus a 'notional' tax credit of 1/9. The tax credit later reduces your tax liability, but cannot be used to create a repayment. The net outcome is that basic rate taxpayers pay no further tax on a dividend, higher rate taxpayers pay tax equivalent to the net dividend x 25%, or 36% for additional higher rate taxpayers from April 2010.

Any higher rate tax you incur on your savings or dividend income is usually payable via Self Assessment. This may require payments on account, and will require a balancing payment on 31 January after the tax year.

9.1 Retaining profits in the company

If you don't need to draw all the company profits, (and you don't want to pay the taxes described above), you may retain them in the company.

9.2 Deductions from Corporation Tax profits

The company pays Corporation Tax on its 'profits chargeable to Corporation Tax'. Profits are the company's income less allowable expenses, plus its chargeable gains.

Expenses include your salary, and the associated Class 1 Employers' NICs. Note that a Corporation Tax deduction is only allowed if the salary is paid within nine months of the end of the company's Accounting Period.

A dividend is different. It is your reward for your investment in the company. It is a distribution of company profits, rather than the company's expense. This means the company cannot claim a tax deduction for paying a dividend, and the dividend is payable after calculating Corporation Tax.

To summarise, Corporation Tax is payable on profits remaining after allowable expenses including salary and Class 1 Employers' NICs, whether or not you plan to take a dividend.

10. Corporation Tax

You self assess your company's Corporation Tax for an Accounting Period. This involves computing 'profits chargeable to Corporation Tax', then calculating the Corporation Tax payable on those profits.

Companies with profits of £300,000 or less pay Corporation Tax at the 'small companies' rate'. This is currently 21%. Companies with profits exceeding £1,500,000 pay 28%. The rate charged on total profits increases as profits increase from £300,000 to £1,500,000.

The small companies' rate will increase to 22% in April 2010.

The £300,000 and £1,500,000 limits described above are reduced proportionately if the Accounting Period is less than 12 months, or if the company has 'associated' companies - basically companies which are under common control, such as by the same shareholders as in the first company.

Unless the company is 'large' (generally meaning companies that pay tax at 28%), Corporation Tax is payable within nine months and one day of the end of the company's Accounting Period.

Disclaimer

The content of these guides is based on tax legislation in operation at the time of publication, which may subsequently have changed. Whilst every care has been taken in its production, no responsibility can be accepted for any action undertaken or refrained from as a consequence of this material. This information is for general guidance only. Specific professional advice should always be obtained based on personal circumstances. TaxationWeb Limited accepts no responsibility whatsoever for any action undertaken or refrained from as a result of the information contained herein.