How is a company taxed, and is it better to be incorporated or self employed?
Following on from last week's article on how unincorporated businesses are taxed, the tax aspects of incorporation now fall under the spotlight.
Corporation Tax
Companies are chargeable to corporation tax instead of income tax and liable to complete corporation tax returns. Other than large companies, who must make quarterly payments of corporation tax, normally any company liability is due nine months after the end of the accounting period.
There are currently two 'proper' rates of corporation tax, the main rate, currently 28% and the small companies rate, currently 21%. The small companies rate applies to companies with profits under £300,000 and the main rate to companies with profits over £1.5m.
Note that these limits are divided by the number of associated companies -- broadly those under common control -- to prevent scurrilous bounders establishing five companies each with profits of £300,000 rather than one with £1.5m profits.
Now the shrewd among you will be wondering whether profits between these two figures actually escape corporation tax. This is not April 1, and we are not in the Cayman Islands, so unfortunately this is not the case. Profits falling between the small company and main rates of corporation tax are taxed at the marginal rate.
On the face of it, the marginal rate looks to be a better option than paying the full main rate corporation tax -- tax is calculated at 28% but a marginal rate discount is then applied, thereby reducing the overall tax due. However, the reality is a little different.
Consider the situation laterally. Profits under £300,000 are taxed at 21%, but by the time those profits reach £1.5m, the rate of tax applied to all profits must be 28%. This means that, in the margin between the two, the effective rate of tax applied to those marginal profits must actually be higher than 28% in order to compensate for the lower rate charged on lower profit levels. As a result, the marginal rate on profits between £300,000 and £1.5m is actually 29.75%.
Now, if that were the end of the story, smart Fools would be foolish to pay 40% or 50% income tax on profits when they could pay a maximum of 29.75% instead. However, if Fools want to extract cash from the company, there are other things to think about, and potential income tax liabilities as well.
Getting money out of the company
A company is a separate legal entity, which is what provides the limited liability companies enjoy. However, this also means that the company's money is not your money until it is officially paid out of the company.
There are two main ways of extracting money from a company; paying a salary (and/or bonus) and paying dividends.
Salary and bonus payments are subject to income tax and national insurance, normally under PAYE, in the hands of the recipient. However, such payments qualify as a deduction for corporation tax purposes, meaning that although there is an income tax liability, no corporation tax will be due on those same amounts. However, there is an added cost of paying salaries in the guise of employer's national insurance contributions. These are broadly 12.8% of gross salary, and although these costs also generate a corporation tax deduction, this is an added overall cost.
Dividends do not generate a corporation tax deduction, but the tax paid by the company means that dividends have an attached tax credit. Provided the value of dividends received does not exceed the basic rate band of tax in the individual's hands, no further tax will be due. If the dividend, falls into the 40% band, an additional 25% tax on the net dividend received will be due, even more if the dividend falls into the 50% band.
This means that it would be possible to take modest dividends and pay no additional tax. However, it is important to note that dividends do not form part of net relevant earnings for pension contribution purposes and that dividends may only be paid out of current or retained profits -- dividends cannot generate a negative position, but salaries can generate a corporation tax loss.
Other issues
There are strict accounting and reporting procedures for limited companies and accounts and shareholder information must be filed annually with Companies House. This information is publicly available to any Bob, Steve or Willy who wants a look.
The main advantage to a corporate structure is that the individual shareholder's liability is limited, normally by shares or guarantee. This means that, should a company be unable to meet its debts, any disgruntled creditors have no recourse to come knocking on the shareholders' doors. In practice, however, especially where small or newly established companies are concerned, creditors such as banks may require personal guarantees from the directors, and trade creditors may refuse to extend credit to reduce their risk.
Unincorporated business v Limited Company
The perpetual question of whether a sole trade or company vehicle is most appropriate will never have a blanket answer, as there are so many different issues to consider. However, from a purely tax perspective, at lower profit levels (under £100,000), on current rates there is likely a small tax advantage to incorporation.
However, if the tabled increase in the small companies rate of taxation ever comes about, and coupled with the 0.5% national insurance increase scheduled for 2011, it is likely the cost savings will become smaller over time. When adding in the additional costs of accounting, tax and other regulatory procedures, the answer is, as ever, related to the length of a piece of string.
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