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Should You Use a Company to Save Tax?

Corporation Tax vs Income Tax

SHOULD I use a company? This is one of the most important tax questions asked by business owners.

For the very latest information on this topic see our tax guide: Using a Company to Save Tax

A UK business can generally be structured as a:

Sole traders and partnerships are taxed in pretty much the same way: the profits of the business are added to the owner’s other income and subject to income tax and national insurance. For the remainder of this article I will refer to both these types of business owner as ‘self-employed’.

Companies, on the other hand, pay corporation tax on their profits, although the owners are subject to income tax and (possibly) national insurance if and when money is taken out of the company.

One of the main reasons why many business owners want to use a company is because corporation tax rates are generally lower than income tax and national insurance rates.

The gap has widened further with the introduction of the new 50% income tax rate for those earning over £150,000 and the withdrawal of personal allowances for those earning over £100,000.

Companies currently pay tax on their profits as follows:

First £300,000                         21%
£300,000 to £1.5m                  29.75%
Over £1.5m                             28%

The self-employed pay the same income tax as everyone else but their national insurance rates are different (8% between £5,715 and £43,875 and 1% on the rest). They also pay a small fixed amount of £124.80 if earnings exceed £5,075.

The total combined income tax and national insurance rates paid by the self employed are as follows:

First £5,075:                            Nil
£5,075 to £5,715:                    £124.80
£5,715 to £6,475:                    8%
£6,475 to £43,875:                  28%
£43,875 to £100,000:              41%
£100,000 to £112,950:            61%
£112,950 to £150,000:            41%
Over £150,000:                       51%

If you plug a variety of business profits into the above corporation tax and self-employment tax tables you will find that corporation tax becomes more attractive when your profits reach around £24,000.

Corporation tax then becomes more and more attractive as your profits grow.

For example, a business with profits of £50,000 will save £2,669 in tax by using a company; a business with profits of £75,000 will save £7,669 in tax and a business with profits of £100,000 will save £12,669.

The savings are most attractive when profits exceed £150,000 – the point where 51% tax kicks in for self-employed business owners.

For example, a business with profits of £150,000 will save around £25,000 in tax by using a company, a business with profits of £200,000 will save £40,259 in tax and a business with profits of £300,000 will save £70,259.

Companies with profits over £300,000 will start paying 29.75% corporation tax but that’s still a lot better than paying 51% income tax and national insurance.

For example, a business with profits of £500,000 will save £112,759 in tax by using a company.

So far, we have looked at the company’s tax position only. We have not factored in the extra tax that may be payable if the owner decides to extract some profits.

However, what we can conclude from the above simple analysis is that:

Companies can be extremely powerful tax shelters when all the profits are retained within the business.

The type of business owner who would be happy to reinvest all of the profits would typically be one who has a second income, possibly from another business. Using a company in these circumstances could potentially leave the business with a huge extra amount of after-tax income to help it grow.

The profits could then be taken out several years down the road or the business could be sold, with the resulting capital gain possibly taxed at just 10%, thanks to Entrepreneurs’ Relief.

Extracting Profits
Of course, most business owners cannot afford to reinvest all their profits – they need money to live on!

The question then becomes: Will using a company save me tax if I extract the profits?

To answer this question we have to take a brief look at how company owners are taxed when money is taken out of the company.

Most company owners are both employees and shareholders of their companies. This means they can extract income as salaries and/or dividends.

Salaries are subject to income tax and national insurance; dividends are subject to income tax only.

Taking a big salary is generally not attractive because the national insurance cost is prohibitive. Up to 11% national insurance will have to be paid on a big chunk of the salary by the company owner personally and an extra 12.8% will have to be paid by the company.

This is far higher than the 8% national insurance paid by self-employed business owners.

But taking all the profits out as dividends is not the best solution for most small company owners either because this means subjecting all the company’s profits to corporation tax (dividends are paid out of after-tax profits).

The best solution in most cases is to pay a small salary that is tax deductible in the company’s hands and tax-free in the hands of the company owner, thanks to the income tax personal allowance and national insurance earnings threshold.

What many company owners do is pay themselves a small salary of £5,715. This is the current earnings threshold for national insurance and means no income tax or national insurance is payable on the salary.

The rest of their income is then taken as dividends. Dividends are effectively tax free if you are a basic-rate tax payer and taxed at 25% to the extent that you are a higher-rate taxpayer.

What this strategy means is that:

Company owners who take a small salary and the rest of their income as dividends can completely avoid national insurance.

Taking a small salary and the rest as dividends is the best solution if your business has pre-tax profits of around £110,000 or less. We’ll talk about companies with bigger profits later.

Company vs Self Employed
The question we are trying to answer here is whether you are still better off using a company if profits are taken out of the business.

The simplest way to answer this question is to compare the total tax bills of self-employed business owners with company owners whose business produces the same level of profit.

We do this in the table below. The table shows the total tax saving you could enjoy by using a company and takes into account ALL the taxes paid by the self-employed business owner (income tax and national insurance) and company owner (corporation tax and income tax).

We assume that the company owner takes a salary of £5,715 and takes the rest of the company’s after tax profit as dividends.

Profits             Tax Saving
£                      £
10,000             273
20,000             973
30,000             1,673
40,000             2,373
50,000             3,709
60,000             3,734
70,000             3,759
80,000             3,784
90,000             3,809
100,000           3,834

Clearly, once your profits are around £50,000, the tax savings become quite significant.

It’s important to point out that these are not one-off tax savings. They can be enjoyed by the company owner every year, subject to changes in tax laws of course.

In the above table we have assumed that all the profits of the business are extracted. But what if, say, 50% are reinvested in the business?

As we know from earlier in the article, companies are extremely powerful tax shelters when profits are reinvested because only corporation tax is payable on the money kept inside the company.

Here are some sample tax savings when only 50% of the pre-tax profits are taken out of the business and the rest (after tax) are reinvested:

Profits             Tax Saving
£                      £
10,000             123
20,000             973
30,000             1,673
40,000             2,373
50,000             3,869
60,000             5,869
70,000             7,869
80,000             9,869
90,000             10,634
100,000           11,384

Clearly the savings now become extremely attractive when the profits of the business exceed £60,000.

Bigger Companies
If your company’s pre-tax profits are between around £130,000 and £300,000 and you wish to extract all of these (after corporation tax), it generally doesn’t pay to take any salary – you are better off taking all your income as dividends.

Company owners who only receive dividends pay income tax at the following rates:

First £39,488                                       Nil
£39,488 to £90,000                             25%
£90,000 to £101,655                           37.5%
£101,655 to £135,000:                        25%
Over £135,000:                                   36.1%

How does paying corporation tax and income tax at the above rates compare with the income tax and national insurance paid by sole traders and partnerships?

Here are some sample overall tax savings enjoyed by company owners who extract all their profits (after corporation tax) as dividends:

Profits             Tax Saving
£                      £
130,000           3,999
150,000           4,049
200,000           6,618
250,000           7,354
300,000           8,091

Clearly, using a company can produce significant tax savings when your profits are somewhere in this range.

Once your profits exceed £300,000, you are better off taking that small salary of £5,715 again (due to the higher rate of corporation tax relief). However, at these profit levels, extracting all of your remaining after-tax profits starts to become counter-productive, as the marginal tax cost on the profits over £300,000 is then more than 55% - more than a self-employed person would be suffering on those same profits.

Few people will really need to extract so much profit every year but, if you do, a company will cease to be worthwhile when your pre-tax profits exceed around £527,000.

As we know, the bigger tax savings come when you reinvest a big chunk of the company’s profits in its business.

The table below indicates the tax savings when only 50% of the pre-tax profits are taken out of the business and the rest (after corporation tax) are reinvested. A salary of £5,715 is beneficial at all profit levels when following this strategy.

Profits             Tax Saving
£                      £
130,000           16,224
150,000           17,724
200,000           24,400
250,000           32,624
300,000           39,771
500,000           46,660

Once again, we see what powerful tax shelters companies are when some of the profits are reinvested in the business.

In conclusion, most small business owners will pay less tax overall by using a company. Tax savings totalling thousands of pounds are achievable if a sizeable chunk of the profits are reinvested to grow the business.

 

NICK BRAUN, MAY 2010