Tax Advantages of Incorporation

The Chancellor believes saving tax is a key incentive driving many businesses to become limited companies. The Chancellor wants to reduce this incentive by using two measures announced in the July 2015 budget.

These measures are ……

  • The removal of the Employers Allowance from companies where the director is the sole employee – saving £80M per year in 2016-17 rising to £110M per year in 2020-21;

Employers Allowance is the first £2,000 of employers NI being waived (£3,000 in 2016 17).

And more significantly

  • Reforming Dividend Tax – saving £190M per year in 2016-17 rising to £565M per year in 2020-21.

Effective tax rates on Dividends received depend on the individual’s gross income.

The new measure will be that the first £5,000 dividend is tax-free, after which taxes on all dividends are being increased by 7.5%.

Base Band (as 20% income tax) effective rate 0% increases to 7.5%

Higher Rate Band (as 40% income tax) effective rate 25% increases to 32.5%   …. and so on

This tax will be applied to all dividend income not just dividend income from closed companies.

The Effect:

Although the exact details of implementation have not been clarified at the time of writing this document, the numbers below quantifies the expected effect of these measures on one-person incorporations.  Income being the money the business makes after allowable costs and before owners salaries or drawings. Annual savings are :

Income          Tax Saving from One-Person Incorporation

£20,000          2015/16  £    912     new system £       471 savings reduction of £   441

£30,000          2015/16  £ 1,812     new system £       771 savings reduction of £1,041

£40,000          2015/16  £ 2,712     new system £   1,071 savings reduction of £1,641

£50,000          2015/16  £ 4,408     new system £ 2,894 savings reduction of £1,514

£60,000          2015/16  £ 4,639     new system £ 2,651 savings reduction of £1,988

£70,000          2015/16  £ 4,839     new system £ 2,251 savings reduction of £2,588

£80,000          2015/16  £ 5,039    new system £ 1,851 savings reduction of £3,188

£90,000          2015/16  £ 5,239    new system £ 1,451 savings reduction of £3,788

The savings will vary due to individual circumstances so please seek professional advice to ascertain exactly what savings you can make.

These savings levels can be significantly increased if the business is formed with two directors and/or shareholders – having one’s spouse being involved with the business can be very tax efficient.

Potential Strategies to increase benefits:

The Chancellor stated that businesses with only one employee would not receive the Employment Allowance, therefore employ someone (spouse) to run the “back office”.

This Dividend Tax may well cause the shareholding of small limited companies to be widened. Existing owners may encourage family members to own shares – allowing partners and children to gain an interest and shareholding. All shareholders will apparently have the £5,000 tax free Dividend Allowance, as well as personal allowances.

When issuing shares (particularly alphabetic shares), it is important to make sure the paperwork is right. In addition, remember that the dividend should be paid into the account of the shareholder.

In Conclusion:

The new changes makes Incorporations involving spouses even more desirable.

Incorporation, particularly to a two-person business, still has significant tax benefits. However Mr. Osborne may surprise us again with the results of the review of Class 2 and class 4 NI being undertaken for the autumn.

The Boring Bit:

Sample calculations.

Sole Trader:

Income                         £ 50,000

Tax Allowance            £ 10,600

20% band                   £ 31,785                                   tax            £   6,357

at 40%                        £   7,615                                    tax            £   3,046

National Insurance

At 0%                        £   8,060                                    NI            £     146 (class 2)

At 9%                        £ 41,940                                    NI            £   3,774

————

Total Tax and NI                                                                        £ 13,323

=======

 

One-Man Limited Business with Current Rules:

 

Income                         £ 50,000 before Salary and NI

Directors Salary            £ 10,560                               NI            £     300

Profit for Tax            £ 39,440                                 tax            £   7,888 corporation tax

Profit After Tax            £ 31,552 taken as dividends

Gross Dividend            £ 35,058

Left from Allow            £          40 (£10,560 only paid above)

At effective 0%             £ 31,825

At effective 25%          £   3,233            *            tax            £       727 * net dividend tax

————

Total Tax and NI                                                                      £   8,915 saving £ 4,408

=======

‘* The effective 25% dividend is applied to the Net dividend before the tax credit.

The calculation is 3,233 x .9 x .25 or   3,233 x (.325-.10)   both equal 727.

 

 

One-Man Limited Business applying new Rules:

 

Income                         £ 50,000 before Salary and NI

Directors Salary            £ 10,898 (inc NI)                 NI            £     638 – includes employers NI

Profit for Tax            £ 39,102                                    tax            £   7,820 corporation tax

Profit After Tax            £ 31,282 taken as dividends, apparently with no grossing up.

Dividend                        £ 31,282

At 0%                         £   5,000

At 7.5%                         £ 26,058                               tax            £   1,971 dividend tax

————

Total Tax and NI                                                                        £ 10,429 saving £ 2,894

=======

 

Two Director Limited Business applying new Rules:

 

Income                         £ 50,000 before Salary and NI

Directors Salary            £ 21,120                                    NI            £     600

Profit for Tax            £ 28,880                                      tax            £   5,776 corporation tax

Profit After Tax            £ 23,104 taken as dividends

Dividend                        £ 23,104 (split between two shareholders)

At 0%                         £ 10,000 (2 x £5,000)

At 7.5%                         £ 12,104                               tax            £       983 dividend tax

————

Total Tax and NI                                                                        £   7,359 saving £ 5,964

=======