In the Chancellor’s last Autumn Statement before the General Election, George Osborne set out his new policies and made changes to some areas of tax. A piece of legislation that some of our clients have found useful has been changed.
Tax relief that had been available in connection with the transfer of an unincorporated business to a limited company has ceased. Other benefits in this area that continue include a possible income tax saving. Let me set out an example.
If a company makes a profit of £10,000, it will then pay tax on that profit at 20% £2,000 – leaving £8,000 profit after tax.
That profit can be paid out to shareholders as a dividend and, if it is paid to a higher rate tax payer, the tax paid on the dividend they receive is £2,000 – the company pays £2,000 and the shareholder pays £2,000 – total £4,000 tax on £10,000 profit, i.e. 40%
Some of the dividend may be paid to a basic rate (20%) tax payer. If 30% of that amount can be paid in that way, then the higher rate tax payer receives a dividend of (£8,000 @ 70%) £5,600 and the basic rate tax payer (spouse, maybe) receives a dividend of (£8,000 @ 30%) £2,400. The higher rate tax payer still has to pay the higher rate tax via the selfassessment tax return on their dividend – which on a dividend of £5,600 is £1,400 and the basic rate tax payer has no more tax to pay on their dividend – the tax is in essence already paid by the company which has already paid 20% tax on their profit.
So, in this example, the total amount of tax to pay is £2,000 by company plus £1,400 by the higher rate tax payer – a total of £3,400.
If, instead of operating through a company, the £10,000 profit is made by an individual ,then his tax bill at 40% is £4,000 – in addition there would be a further 2% National Insurance (N.I.) charge – total tax cost of £4,200.
So, the example where 30% of the dividends are paid to a basic rate tax payer through a company, saves tax of (£4,200 £3,400) £800 for every £10,000 in profit – 8%.
There are, of course, a number of other factors to consider but broadly the details above do not represent any simplification, subject to changing tax thresholds. That is how the tax rates and figures work.
Other items that are interesting are as follows:
1. The sole trader and company can generally claim the same deductions for expenses, but greater care is needed when working through the process, as it is easy to make mistakes.
2. A sole trader or a company may pay salary to a spouse, providing the spouse is working and earning that salary from the business and the level of salary can be justified by the amount of work they done.
3. In a similar way a company or sole trader can contribute to a pension fund for the worker (again subject to the payments being commensurate with the amount of work performed).
4. There is further scope for a company to manage the timing and amounts of dividend, to further reduce the tax bill in the short term. e.g. if a sole trader makes £100,000 profit, their tax and N.I. bill at 40% plus 2% N.I. is £42,000. A company, assuming £20,000 of the profit was not taken during the year but left in the company, corporation tax is still payable at 20% of the £100K profit but the dividend total would only then be £60k (£100K – £20K corporation tax – £20K profit not drawn).
Basic rate taxpayers’ share of dividend (30%) is £18,000 and higher rate tax payers share is £42,000. Their income tax bill on this would be £10,500 ,add the £20,000 tax paid by the company – total tax of £30,500 on the same £100,000 profit that the sole trader would have paid tax of £42,000 on – a tax saving of £11,500 – 11.5%.
Whilst the amounts saved (i.e. 8% and 11.5%) do not sound like immense percentages – over the years these add up and the 11.5% saving represents an actual reduction of more than one quarter to the total tax paid.
Also a company is able to pay corporation tax significantly later than the sole trader, so there is a cash flow timing benefit too.
These details are just a simple introduction to some of the tax planning that is possible and that we undertake for our clients on a daily basis. Please get in touch if the details outlined here are of interest or if there are you have further tax questions or face other issues.
