Sole Trader vs Ltd company question - Pension

[SpongeBob]

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Hi all,

I'm thinking about becoming a limited company, as while I've been a sole trader for many years I think that it would be nice to have limited liabilities, plus I thought that you could save tax as a limited company.

I've got a few questions that I'm wondering about, though, but for now I'll just ask one.

Basically, are you much better off as a limited company?

I've downloaded the spreadsheet from HRBS's site ( Save Tax and National Insurance | Pay Dividends | Company Formation : HRBS.biz | Fixed Fee Accountants | Free Guides | Save Tax | VAT Advice | Self Employment Help ) and put in £100,000 for the expected profit (a round number to try it out) and left the other fields as they were. It says that I could pay £14,386 less tax as a limited company. Now, that sounds great, but it's achieved by having left 42k in the company - at some point I'd need to withdraw it and I'd pay tax then. If I assume I'll be a high rate tax payer for some time, then I would have to pay full tax on that at some point, so for me that figure isn't quite right.

So, I change the spreadsheet to say I want to withdraw the maximum dividend available, i.e. 74k. It then says I'd save £3,797. That's great - it's an amount that's worth the hassle of changing.

However - now for the bit that I'm less certain about. That assumes you pay a salary of £5,500. If you increase that you pay more tax. But, I want to be able to pay a decent amount into a personal pension and the maximum I can put in is equal to my salary, as I understand it. So if I pay myself the minimum salary then I can't pay a lot into the pension.

So - if you also pay a decent amount into a pension how do the figures stack up? If you increase the salary to enable you to pay more into a pension then your tax liability goes up reducing the tax advantage of a limited company. Is that correct? Or do you handle pension contributions differently, e.g. having the company pay into the pension? In which case, how do the figures stack up then?

[hrbs]

So - if you also pay a decent amount into a pension how do the figures stack up? If you increase the salary to enable you to pay more into a pension then your tax liability goes up reducing the tax advantage of a limited company. Is that correct? Or do you handle pension contributions differently, e.g. having the company pay into the pension? In which case, how do the figures stack up then?

Hi

Thanks for downloading the spreadsheet. The tax/NIC rates are for the current tax (2008/09) and assumes a company and sole trader year end of 31 March/5 April. Updating the rates for 2009/10 gives a tax/NIC saving of just over £4k if you withdraw all profits from the business. Still quite a decent saving given that all profits have been withdrawn from the business.

For those whose profits are, say, £50K running the business via a limited company gives a net income of approx £ 40K (assuming all profits are withdrawn and no other sources of income).

The savings come about because as a sole trader you would be paying class 4 NIC in addition to higher rate tax on your profits. Dividends are not subject to NIC. NIC and income tax rates are increasing in 2011/12. Corporation tax rates may increase to 22% from April 2010, depending upon the state of the economy but may remain at 21% given that there will a general election coming up. Tax rules change nearly every year based on the state of the economy and governmental politics. [The proposed tax/NIC rates are at http://www.hmrc.gov.uk/pbr2008/ ]

Running a business through a limited company allows you to plan your personal tax liability and smooth your personal income, especially if the business is volatile i.e. fluctuating profits for a sole trader could mean that one year you pay higher rate tax and another year basic rate. Companies also benefit from paying tax 9 months after the year end.

On another wider point , for someone who has a "day job" and the total of their employment and self-employment profits takes them into higher rate, running the business via a limited company allows them to build up a nest egg in the company should they decide to run it fulltime, are forced into it by redundancy etc. The amount of the nest egg depends upon how much dividend is withdrawn whilst they have the 2 sources of income. The most tax efficient option in this scenario is to withdraw dividends which will make the most of your basic rate band. (see http://hrbs.biz/id?313)

I have a number of clients who have done this whilst they had a job. When they went working for themselves fulltime, they had retained a few years worth of income in the company. They choose whether or not to take themselves into higher rate tax and can withdraw upto £40k pa (based on 2009/10 rates) from the company tax free as the company has paid corporation tax on the profits. If the business' profit dips then they have the comfort of being able to maintain their current personal income level for a few years whilst the business regains its ground.

With regards pension, this can be paid by the company and it will be tax deductible in the company. The main current HMRC criteria for the tax deduction is that the salary package is commercially justifiable ie the total salary/pension/benefits is at a commercial rate. If you paid it personally you would get tax relief on the maximum of £3,600 or your earnings for the year (dividends are not classed as earnings for this purpose).
HMRC guidance on tax relief for pensions is at http://www.hmrc.gov.uk/incometax/relief-pension.htm .

The pension contribution rules from 1 April 2006 are at http://www.direct.gov.uk/en/MoneyTax...ns/DG_10027106

The rules regarding pensions are potentially complex, so if you intend to make sizeable contributions, then I would suggest getting specialist advice from a pensions advisor and your accountant.


Regards

Keith
http://HRBS.biz

[Stuart]

I have a number of clients who have done this whilst they had a job. When they went working for themselves fulltime, they had retained a few years worth of income in the company. They choose whether or not to take themselves into higher rate tax and can withdraw approx £40k pa (based on 2009/10 rates) from the company tax free as the company has paid corporation tax on the profits. If the business' profit dips then they have the comfort of being able to maintain their current personal income level for a few years whilst the business regains its ground.

Sorry to jump in. Very interesting but slightly confused. If you take 40K from the company nest egg after corporation tax has been paid, the company still needs to pay the personal tax and NI on the 40k you take out, if 40k can be Net pay so its costs the company 40k + tax and NI?

So its not tax free???? Pleae clarify

[hrbs]

If you take 40K from the company nest egg after corporation tax has been paid, the company still needs to pay the personal tax and NI on the 40k you take out, if 40k can be Net pay so its costs the company 40k + tax and NI?

So its not tax free???? Pleae clarify

Hi

The £40k for 2009/10 is tax free as it is not all salary. It is a mix of salary (below your personal allowance so no tax payable) and the balance is dividend (within basic rate band and therefore no personal tax to pay). This method is the one shown in the spreadsheet downloaded by SpongeBob (http://hrbs.biz/id?313 ). The illustration assumes that you have no other income nor make personal pension contributions in the tax year.

For example, using 2009/10 rates (figures are total for the tax year):
Salary £6,400, less NIC of £163 = £6,237
Net Dividend £33,600
Total £39,837

or Salary £5,700 (no NIC)
Net dividend £34,358
Total £40,058

Some people like to pay a small amount of NIC, hence the 2 examples.
The net dividend is the amount paid by the company. Dividends are grossed up when calculating your personal income.
ie gross dividend = net dividend x 10/9 , £9k dividend paid by the company = £10k gross dividend

If you have other income and/or make personal pension contributions, then the above figures will need to change to take them into account. The NIC and income tax rates are at HM Revenue & Customs: Taxes, National Insurance and Stamp Taxes .


Regards

Keith
http://HRBS.biz

[Stuart]

OK, thanks for clarifying that, I was thinking about a scenario where I/We/you had other income...

Ta
Stuart

[SpongeBob]

Thanks for the detailed reply, HRBS!

Running a business through a limited company allows you to plan your personal tax liability and smooth your personal income, especially if the business is volatile i.e. fluctuating profits for a sole trader could mean that one year you pay higher rate tax and another year basic rate.

In my case that may not be an issue as I've been well into the 40% for years and would hope to be for many more years. I don't think I'd want to postpone taking money out of the company for too many years. But for those who are nearer the 40% band then I can see how it could be very beneficial.

With regards pension, this can be paid by the company and it will be tax deductible in the company. The main current HMRC criteria for the tax deduction is that the salary package is commercially justifiable ie the total salary/pension/benefits is at a commercial rate.

Does that mean that if I was to earn 100k I could pay myself the basic 5.5k salary, pay 20k (say) into a pension and then take the rest out of the company as dividends? I'm still not sure whether that's possible (paying such a high amount into a pension relative to the low salary) or whether overall I'd be better/worse off doing that compared to if I remained as a sole trader paying 20k into a personal pension.

The rules regarding pensions are potentially complex, so if you intend to make sizeable contributions, then I would suggest getting specialist advice from a pensions advisor and your accountant.

Thanks - yes, I thought it might make things complicated. My contributions into a pension have been a little erratic, as in my early years as an affiliate I wasn't really earning huge amounts. Then I had a few of good years but didn't get round to starting a pension, then a couple of years ago I put north of 50k into a pension to kick start it, then I've had a year or two where I've not contributed anything.

I really ought to put money in each year and I'll be putting another lump sum in this tax year, though not as much as before. But earnings can be uncertain in this business, and the amount I want to put into a pension can also depend on the markets (I'm wanting to put more in now and over the next few years while the markets are low, then could put less in later) and how much I need for other things, e.g. if I need a new car or want to start saving for a new house.

As a sole trader I can put whatever I like (pretty much) into a pension and get the full tax benefit. Whereas it looks like converting to a limited company would place limitations on that, meaning that if one year my business did really well and I wanted to put a big lump sum in the pension then I could lose some of the tax advantages I'd have got from having a limited business.

I suppose if things work out no worse than if I was a sole trader then it could still be worth doing, but it does make it a little harder to work out if it's actually worthwhile...

[max99]

Okay, sorry if i'm being naive, so lets say person A makes £60,000 profit this business year. They are currently a sole trader.

using what you say, they become a limited company, get a salary of £5,700 so no NIC paid, at the end of the year, then take a dividend of £34,000, i would pay no tax on that as income myself. Just corporation tax which would be ... ?

have I kinda got the idea ?

[hrbs]

Okay, sorry if i'm being naive, so lets say person A makes £60,000 profit this business year. They are currently a sole trader.

using what you say, they become a limited company, get a salary of £5,700 so no NIC paid, at the end of the year, then take a dividend of £34,000, i would pay no tax on that as income myself. Just corporation tax which would be ... ?

have I kinda got the idea ?

Hi Max,

I hope I have understood your question properly.
The profit has to be earned by the limited company, you can't transfer the sole trader profits into the company at the end of the tax year. The £60k earned as a sole trader would be taxed as a sole trader.

However, for example, if you ceased as a sole trader on 31 March 2009 and transferred the business to the limited company on that date. The company starts to trade on 1 April 2009 with a year end of 31 March.
For the year ended 31 March 2010, £60k profits (before salary) would be taxed as follows.
Taxable profit £60,000 - £5,700 (salary) = £54,300
Corporation tax @ 21% = £11,403
Company profits after tax £42,897
Net dividend paid £34,358
Profits left in company £8,539

Your personal net income from the company £5,700 + £34,358 = £40,058 .
Your gross income for tax purposes would be £5,700 + £38,175 (dividend grossed up) = £43,875. If you have personal bank interest/other income then you would need to reduce the dividend to take this into account otherwise you would be straying into higher rate tax.

Bear in mind that the company can only pay dividends if it has sufficient profits after tax.

I have updated the spreadsheet with the 2009/10 rates, it can be downloaded at http://hrbs.biz/id?313 .

A guide on how to form a limited company is at
http://tips.hrbs.biz/limited-company...mited-company/ and a checklist of the information need is at http://hrbs.biz/id?314 .

Regards

Keith
http://HRBS.biz