Practical guide: Is incorporation still worthwhile?

Recap - trading vehicle

The business vehicle chosen by a business will determine the taxes and NI contributions that are payable. If a business owner chooses to operate as a sole trader, they will pay income tax on any profits that they make. The profits from their business will be included along with any other income that they may have and their tax liability for the year will be calculated by reference to their total taxable income. Self-employed traders will also pay Class 2 and Class 4 National Insurance contributions where profits exceed the relevant thresholds.

However, if they choose to operate via a limited company, it is a separate entity and will pay corporation tax (CT) on its profits. If the owner manager wishes to use those profits outside the company, they must be extracted. There are various options here, but a popular profit extraction strategy is to take a small salary plus dividends. Depending on the level and any other income, the individual may pay income tax and employees’ NI and the employer may pay employers’ NI. However, the salary level is usually set to minimise NI.

It's crucial to understand that the company is a distinct legal entity. In practice, the confusion over this can often lead to company money being appropriated by the owner without the proper procedures being followed.

Dividends can only be paid out of retained profits, and the profits from which dividends are paid have already suffered CT. Dividends are taxed at a zero rate to the extent that they are sheltered by the dividend allowance and any unused personal allowance. Thereafter they are taxed at the appropriate dividend tax rate, being treated as the top slice of income.

Changes - April 2023

CT rate. From April 2023, the CT rate will rise to 25% for a standalone company with profits in excess of £250,000. A small profits rate, equal to the current rate of 19%, applies where profits are £50,000 or less. Between these rates, the effective rate is between 19% and 25%, being calculated at 25% of taxable profits, less marginal relief. The increase will not affect standalone companies whose taxable profits are £50,000 or less. However, personal and family companies with taxable profits exceeding this will pay more corporation tax from April 2023. This will reduce the profits available to extract as dividends.

Bands and rates. The personal allowance and basic rate bands are unchanged for 2023/24 at, respectively, £12,570 and £37,700 (meaning higher rate tax of 40% is payable on income in excess of £50,270). However, the additional rate threshold is to fall to £125,140. The NI thresholds have also been frozen.

Dividends. The dividend allowance is also to fall from 6 April 2023, to £1,000 from the current level of £2,000. This will reduce the dividends that can be extracted tax free and reduce the benefit of an alphabet share structure to utilise the dividend allowance of family members. The dividend rates, increased by 1.25% from 6 April 2022 as part of a package of health and social care measures, will remain at this level, despite the cancellation of the Health and Social Care Levy and temporary NI increase. The dividend tax rates for 2023/24 remain at 8.75% where dividends fall in the basic rate band, at 33.75% where dividends fall within the higher rate band and at 39.35% where dividends fall in the additional rate band.

Impact on owner managers

Let’s look at the impact this will have on the company v sole trade comparison, assuming a profit extraction strategy consisting of a salary of £12,570 and all remaining profits extracted as dividends.

Note that this may not be the optimum strategy, we are simply making the assumption to keep things simple here.

The tax and NI payable by a single director company and individual at three profit levels are shown below:

	£	£	£
Profit	55,000	120,000	270,000
Salary	(12,570)	(12,570)	(12,570)
ERs’ NI	(479)	(479)	(479)
Taxable	41,951	106,951	256,951
CT	(7,971)	(24,592)	(64,238)
Dividend	33,980	82,359	192,713
Income tax	(2,886)	(18,283)	(65,673)
In-pocket position	43,664	76,646	139,610

The personal allowance is fully abated once adjusted income exceeds £125,140, meaning that once income reaches this level, tax is paid on the first £1 of income (subject to the dividends covered by the dividend allowance). The dividend allowance will fall again in April 2024, to just £500.

Now let’s look how the sole trader will fare at the same profit levels:

	£	£	£
Profits	55,000	120,000	270,000
Personal allowance	(12,570)	(2,570)	0
Taxable	42,430	117,430	270,000
Income tax	(9,432)	(40,232)	(107,703)
Class 2	(179)	(179)	(179)
Class 4	(3,488)	(4,776)	(7,788)
In-pocket position	41,901	74,813	154,330

Verdict

The comparison paints a similar picture to the position that has been prevalent since the changes to dividend tax in 2016 - namely that incorporation is still worthwhile at relatively modest profit levels, but once profits increase significantly, the sole trader will retain more.

Additionally, it is worth noting that the advantages are quite small. At the two profit levels where the company owner is better off, the difference is only approximately £1,600. As companies are subject to a higher administrative burden than unincorporated businesses, the relatively small savings might not be enough to consider incorporation for tax/NI reasons alone. However, that doesn’t mean incorporation should be off the table. There are a number of factors you will need to consider:

• the examples assume all profits are extracted. A better result could be achieved by restricting this, e.g. so that the director shareholder does not enter the personal allowance abatement range
• the company example is based on a single director shareholder. Things could be greatly improved if multiple tax allowances and basic rate bands could be used, e.g. by having a spouse/civil partner as a second shareholder
• the examples assume there is no other income. In reality, this would need considering so an optimal profit extraction strategy can be devised.

The overall conclusion is that while incorporation can still offer tax and NI savings, there is no one-size-fits-all solution, and you should make your decision based on your own individual circumstances.

Additionally, there are numerous non-tax incentives for incorporating, including:

• the benefits of limited liability to protect personal assets
• perceived prestige
• ensuring continuity of the business in perpetuity
• ease of succession planning.