With recent tax changes and more coming in 2023, Leona Bateman, Partner at Elsby & Co examines whether tax motivated incorporation tax still has a place.
Historically, tax and national insurance (NI) savings could be made by transferring a sole trader business to a limited company. In 2016 a sole trader with profits of £100,000 would keep just over £66,200 after tax and NI, however a director shareholder of a single person company would keep just over £71,000, a near £5,000 saving. As accountants our advice was simple and straightforward.
In 2022/23 a sole trader would keep £66,800 and the director shareholder would keep £68,600, but the saving has been reduced.
In 2023, corporation tax increases to 25%, though companies with profits of £50,000 or less will continue with the 19% rate. Where profits don’t exceed £250,000, marginal relief can be deducted to reduce the effective rate of tax. This change has a significant impact on the decision to incorporate.
Assuming the accounting period falls wholly after 1 April 2023, the sole trader is in a similar position as 2022/23, keeping just under £67,000 after tax and NI. This makes sense as sole trade profits are not subject to corporation tax.
However, the director shareholder’s position is affected as profits after deducting the director salary of £12,570 (the optimum position due to increases in the primary threshold) fall into the marginal relief band. The corporation tax bill increases, leaving less distributable profits to take as a dividend. The result being our director shareholder keeping £67,000, putting them on a par with a sole trader.
The future for incorporation
When considering whether to incorporate following the 2023 rate increase, it’s unlikely to be worth doing from a tax angle alone, unless there’s certainty that profits will remain around £50,000 to £75,000.
The tax efficiency could increase depending on circumstances. If the director shareholder doesn’t require all the profit to be extracted every year, profits can be left undrawn as dividends, but won’t be subject to income tax until withdrawn. If this takes place in a later year, when profits are lower, they could be subject to a lower rate of dividend tax.
The company could also use any undrawn profits to make investments in its own name. This doesn’t solve the tax efficiency issue but could increase the distributable profits going forward. Another option is using undrawn profits to make pension contributions as the employer. These would be deductible for corporation tax, but the downside of money being locked away.
If these options aren’t suitable, a good strategy is to bring a spouse or civil partner as a second director shareholder. This would eliminate secondary class 1 NI contributions and would have a big effect on the corporation and income tax charged.
Assuming no other income, both directors would withdraw a salary, saving corporation tax of up to 25%, with income paid enjoying the benefits of two personal allowances, basic rate bands and dividend allowances.
In a company with profits of £100,000 and assuming director salaries of £12,570, corporation tax falls by over £3,000. Assuming an equal dividend split, neither director shareholder breaches the higher rate threshold, and the income tax bill is less than £5,000. Overall, the change to a two-person company saves over £12,000, leaving our happy couple with £79,200.
The days of the old ‘one-man (or woman) band’ companies may be numbered, but there’s still a place for incorporation with tax savings in mind.
For a free consultation or to hear how Elsby can help mitigate your tax, please e-mail leona.bateman@elsbyandco.co.uk