As the business and profits grow, the sole traders’ personal tax liability will also increase, as will their exposure to risk.
When the business gains this traction, it may be time to consider incorporating. Note that when a business is incorporated the Directors will then have an obligation to file annual accounts and Corporation Tax returns.
The tax benefits of limited companies are not what they used to be with the reintroduction of the higher rate of corporation tax.
Corporation Tax Rates
The corporation tax rate applicable before April 2023, was a flat 19%.
From April 2023 the rates of corporation tax are as follows:
Companies with profits under £50,000 = 19%
Companies with profits over £250,000 = 25%
Companies with profits exceeding £50,000 but not exceeding £250,000 = marginal relief. The marginal relief calculation is complicated (you can find it here if you’re interested), but broadly the marginal rate of tax (for the amount of profits between £50k and £250k) is 26.5%.
Directors of limited companies
The benefits that limited companies do offer us are flexibility over cash extraction and limitation of liability.
Unlike a sole trader, a Director of a limited company is protected by what we call the veil of incorporation. Debts (for which no personal guarantee has been given) are generally ring fenced in the company providing Directors and owners with protection.
Likewise, profits accumulating in the company can be allowed to accrue and held in profit reserves to be extracted as and when shareholders desire. In contrast to sole traders, who are personally taxed on business profits in the tax year in which they arise.
Directors also have access to their Director’s loan account, which can be overdrawn throughout the financial year to give Directors access to tax free cashflow (providing the debt is cleared either by repayment or by declaring a dividend before the corporation tax payment due date).
Tax planning opportunities
It is possible to implement different classes of shares and Income / Capital Gains tax planning is also much easier.
An illustrative example of the tax payable by both the company and the Director / Shareholder and the resulting net cash position, is given below. Illustration 1 shows the position where one individual owns the entire issued share capital. Illustration 2 provides indicative figures assuming two shareholders. Both illustrations assume that of the £100k profits all available reserves are extracted in the financial year and that the Directors / Shareholders have no other sources of income. Under illustration 2 the total tax is reduced by, and therefore the net cash position is increased by c £8k. Good planning!
Illustration 1
Illustration 2
