Many individuals who are self-employed, either on their own account or in partnership, will from time to time consider whether it might be to their advantage to operate as a limited company (usually referred to as “incorporation”). In most cases careful thought will be required to consider the advantages or disadvantages of this step and even when the decision to proceed with incorporation has been made, important issues need to be addressed to ensure that the incorporation is tax effective. Some of these are reviewed below.
Advantages/Disadvantages of Incorporation
There are a number of practical and commercial reasons why incorporation is sometimes attractive. Many people find it easier to regulate their business relationship through the medium of a limited company rather than the vaguer collection of rights and duties which constitute a partnership. In some markets the perceived status that goes with trading as a limited company is important and in certain circumstances the limited liability status which companies may offer is an important consideration. A business interest which is represented by shares can be transferred simply and thus ease succession and inheritance tax planning if it is intended to transfer an interest in the business to other members of the family. However, the automatic annual tax savings that were available to very small businesses when incorporated a few years ago have mostly now been eroded by changes in legislation but for high earners, especially those with potential income above the £100,000 threshold at which personal allowances are lost and/or the £150,000 threshold at which the 50% (45% from 6 April 2013) income tax rate commences, the savings can be considerable in the right circumstances.
Incorporation also provides a more flexible arrangement and offers more tax planning options depending upon the levels of profit and the individual circumstances of the directors/shareholders. In particular the ability to take tax dividends from company profits, free of any national insurance liability, can be very attractive as can the reduced levels of taxation applied to profits retained in a company (currently 20% up to £300,000 p.a. and thereafter 24%/25%) compared to income tax rates (up to 50% from 6 April 2010) plus Class 4 National Insurance of 9% on profits of between £7,605 and £42,475 and thereafter at 2%. Furthermore, where the annual salary drawn by a director/shareholder in a limited company is low (say £6,000 to £7,500) then whilst the resultant Class 1 National Insurance contributions are nil or negligible, credit is given for state retirement benefit calculations as if earnings were £14,700 (2012/13). This is in contrast to Class 4 National Insurance contributions (percentage of profits) paid by the self employed which give no state benefit entitlement and Class 2 National Insurance contributions (flat rate weekly payment) which only give the basic entitlement with no Second State pension benefit.
Against the above it needs to be borne in mind that transferring a business to a limited company will increase the regulatory burden on the business proprietor, probably lead to an increase in the legal and professional fees of running the business and impose a new set of duties and responsibilities on the trader in the their new role as a company director which cannot be taken lightly. In particular consideration will need to be given to the National Minimum Wage regulations and whether they apply to each company director (which is dependent upon whether the director is just an officer or an officer and employee).