Home > The Basics > Coping with companies: incorporated sole traders

Coping with companies: incorporated sole traders

So, you’ve run your business successfully for a while now, and your accountant suggests you transfer the business to a limited company for tax reasons. Eighteen months later, your tax bills seem higher than ever and your adviser is muttering something about ‘section 419* tax’. What’s going on?

When you’re a sole trader, there is no legal difference between your money and the business’s money (although you’re strongly advised to keep a separate bank account). You are charged to tax and National Insurance on your income less your allowable business expenses. Depending on how successful you are from year to year, you may be a higher rate taxpayer; you may have to make payments on account every six months; you may get the odd refund when business drops.

When you incorporate, you create a brand new taxable entity: Joe Bloggs Ltd is totally separate to Joe Bloggs, even if Joe Bloggs owns all the shares. Now all the profits are taxed on the company, currently at 21%, which is pretty funky when you compare it to the 28% or 41% effective rates for sole traders.

If you’ve an adviser worth paying, you should be on a minimal salary in the region of £5,500: this earns you a qualifying year for your state pension without causing a National Insurance charge for you or the company. The rest of your earnings will be dividends from the company, which are effectively tax free for basic rate tax payers.

To be a basic rate payer, your total income must be less than £43,875 (2010/11), but dividends count £10 towards this for every £9 you receive thanks to their tax credit. So, in order to not pay any income tax, dividends need to be kept at about the £34,500 level. Together with your salary, your take-home ‘pay’ is £40,000.

This is where the problems begin. Because you’ve been successful in the past, you may have had more than £40,000 to spare each year. In fact, the company is still making much more than this, and profits are increasing because you’re working harder, or because the business seems more ‘legit’ because it’s a limited company. The company may have six figures in the bank which you’ve nothing to spend on for the business. But you could do with a new car…or an extension…or a month in the sun.

So you take the money…

‘…which includes umpteen-thousand section 419* tax.’

You’re only entitled to your £40,000. Any more you take out of the company (which you may still be thinking of as ‘drawings’), is a loan from the company to you. Implications: an effective 1.9% tax on you personally, National Insurance payable by the company at an effective rate of 0.5%…and tax of 25% of the amount loaned on the company.

There is good news. Every £1 you pay back to the company, the company gets its 25p back from HMRC: but to do that you’d have to seriously curb your spending habits. Still, it’s better than increasing your dividends to match your spending: the tax is still effectively 25%, but it’s on you personally…and you don’t get it back.

The moral of the story: if you don’t need the money, you won’t pay the tax. If you do, you will, but talk to your adviser before you act to discuss what the best way might be to get the funds you require.

* This is technically now section 455 tax, but accountants can be slow to embrace change…

Categories: The Basics Tags: , , ,
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  1. July 9, 2010 at 10:08

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