What are the key advantages and disadvantages of trading as a self employed sole trader vs a limited company for the 2017/18 tax year?
Making the decision as to which structure your business operates as can be crucial, whether that be in terms of tax savings, perception to the outside world, keeping things simple or future plans you may have.
In this article we will review some of the main differences between trading as a self-employed sole trader compared to a limited company, in terms of the tax consequences, administration and other non-financial aspects with regards to the 2017/18 tax year.
Our advice in this article about the topic of sole trader or limited company is geared towards freelancers, contractors and modern small business owners as that is our main area of expertise.
Tax
For this article we will focus only on the 2017/18 tax year.
Our tax comparisons assume a simple position where the only income being earned by a person is either their sole trader income or their salary and dividends from their limited company i.e. there is no other personal income to consider, such as rental income.
Sole Trader Tax
As a sole trader an individual must pay tax on all profits over and above their personal allowance, for most tax payers the personal allowance is £11,500 for the 2017/18 tax year.
Once the personal allowance has been breached tax is paid at the rate of 20% in the basic rate of tax (up to £45,000 income), 40% as a higher rate taxpayer (over £45,000) and 45% in the additional rate band (over £150,000 income).
There are now slightly different tax rates for Scottish taxpayers which are not covered in this article (for 17/18 Scottish taxpayers have a higher tax band of £43,000, not £45,000 like the rest of the UK).
There are also further personal tax issues to consider such as child benefit starts to be withdrawnonce your income goes over £50,000 and the personal allowance begins to be withdrawn once your income is over £100,000.
As well as tax, for a sole trader there will be two forms of national insurance to consider, Class 2 and Class 4.
Limited Company Tax
A limited company, on the other hand, pays corporation tax on profits at a rate of 19% from 1 April 2017 (previously 20%), over and above this there can be personal income tax to be paid with regard to dividend extractions from the business.
In order for the extractions to be as tax efficient as possible the director normally would draw a small salary from the company within their personal allowance but not above the point at which national insurance becomes payable, this salary would be an allowable business cost for corporation tax so 19% corporation tax is saved on the gross salary.
The remainder of their withdrawals would be in the form of dividends, these are paid out of post-tax profits and are not deductible expenses for corporation tax purposes so offer no tax saving, however there is no national insurance to pay on dividends.
In the 2017/18 tax year dividends are taxed at 7.5% in the basic rate of tax, with rates of 32.5% & 38.1% in higher and additional rates respectively.
The first £5,000 of dividends that would otherwise be taxable at the above rates are currently subject to a tax free allowance (called the ‘dividend allowance’).
There is no requirement for the owner to withdraw all profits from the business if they do not want to, and indeed it can prove tax efficient to leave some profits retained in the company for extraction at a later date or to re-invest in the company (e.g. to invest in equipment or staff).
In the table below we outline the tax savings of a limited company compared to a sole trader for different levels of profits based on the 17/18 tax year.
We have assumed an optimum level of salary and dividends in the scenario of a limited company and the figures include national insurance payable as a sole trader.
The profits are on a like-for-like basis so do not include the directors salary for the limited company.
Tax differences of a sole trader vs limited company for 17/18:
So for example looking at this table, comparing the tax rates on sole trader or limited company, you can see that for profits of £40,000 the tax and NI for a sole trader totals £8.7k compared to the combined tax of a limited company (corporation tax on profits and income tax on dividends) totaling £7.4k, so there is a £1.3k saving by using a limited company.
The above table shows that where all post-tax profits are withdrawn from the limited company the savings do not continue to increase as profits rise past £55,000, the optimum level in this scenario is approx. £54,000 of profits.
Whilst there are tax savings at all levels of profitability the extra administration costs (discussed further in this article) can exceed the tax benefits at lower profit levels.
USMAN & CO. ACCOUNTANTS 