Limited companies are known for having a very tax-efficient business structure. Besides a limited company appearing more professional and offering some financial protection, it's these tax advantages that cause many contractors to set up a limited company or PSC.
Sole trader versus limited company
Most contractors, consultants and freelancers find that setting up as a sole trader is the simplest and quickest way to starting their own business – you inform HMRC that you’re self-employed and fill in the self-assessment tax form annually. Statistics show that being a sole trader is the most popular type of business in the UK: 3.4 million of the UK’s 5.6 million small businesses fell into this category at the start of 2018.
Establishing and running your own limited company, on the other hand, is more complex. You can still set up a limited company as a one-person business. The difference is that the company is a distinct legal entity from the business owner. When you form a limited company, you serve the business as its director and you are responsible for the legal and financial decisions your business makes.
Responsibilities include registering your limited company with Companies House, completing and filing annual accounts and confirmation statements with Companies House every year, sending HMRC your accounts, completing an annual Corporation Tax return, sending a personal tax return and more. However, many limited company owners find that the financial advantages far outweigh the additional financial and administrative responsibilities they face.
Here are some of the main tax benefits of running a limited company:
Pay less tax on profit
Sole traders’ personal and business profits are indistinguishable, which means they must pay tax on all their profits that are above their personal tax allowance (£12,500 for the tax year 2019/20), plus they’ll pay a higher 40% tax rate on any income above £50,000. Limited company owners don’t face this issue. Instead, they pay corporation tax on their profits at a flat rate of 19%, and salaries are a deductible business expense for the company.
Reduce your income tax and National Insurance Contributions (NICs)
As the director and shareholder of a limited company, you may choose to take a small salary and draw most of your income from the business in the form of dividends. By doing this, you can minimise the amount of NICs you have to pay. That’s because limited company dividends are not subject to NICs.
Most limited company directors choose to pay themselves a salary up to the Class 1 National Insurance primary threshold – no income tax applies to earnings up to this limit. They then top up their salary by taking dividends. The first £2,000 of dividend income in a year is tax-free. Anything above that you will pay dividend tax on, but you will not have to pay any more income tax or NICs because you’ve already paid corporation tax on this money.
Hold onto surplus cash
As a limited company owner, you’re not obliged to withdraw all company funds every tax year. You can leave some of your surplus income in reserve to use or withdraw at a later date. By being able to manage your money in this way, you can defer your personal tax by withdrawing some of your profits later when it is more tax-efficient to do so. Sole traders do not have this option available to them.
Pensions are tax-deductible too
Limited companies can choose to make pension contributions on behalf of its employees or directors.
While the pension rules are complex, broadly speaking, the contribution paid by the limited company is corporation tax-deductible and, assuming the contribution falls within the person’s available pension allowance, will not be taxed on the individual until they draw it out of their pension.
Claim more business expenses
Limited company owners benefit from being able to claim more business expenses than sole traders. HMRC has strict rules about what can be claimed for, so do check, but expenses generally cover business-specific items such as business trips (including meals while working away), stationery and business cards, mileage allowance and employee mobile phones. Any money you claim in expenses will be deducted from your limited company’s profit and is not subject to tax.
Ensuring business as usual under IR35
Despite these clear tax advantages, limited company contractors face a challenging future. HMRC’s changes to existing IR35 legislation means that public sector (and soon to be private sector) organisations employing contractors working through limited companies are now responsible for deciding whether they are inside or outside of IR35 and therefore must pay more tax and national insurance. It’s forcing many limited company contractors to review their options, including reverting back to a sole trader. However, it is still possible to operate as a limited company contractor and fall outside of the new rules - even if one of your contracts is deemed to be inside IR35, you can still manage this through your company.
To find out more about the advantages of a limited company structure and how you can prepare yourself for the upcoming IR35 tax reforms in the private sector, head to our Knowledge Hub. Please also get in touch with our team of experts to discover how we can help you determine your own IR35 status for each contract and comply with the new rules.