Transferring a sole trader business to a limited company was historically an easy way of saving tax and national insurance (NI). However, a succession of changes since 2016 have largely curbed the tax efficiency.
It all began with the reform of dividend taxation in 2016. Before this, dividends were treated as being received net of a notional tax credit. This was deductible in the self-assessment tax computation and meant any dividends that fell into the basic rate band did not actually suffer any tax.
The 2016 changes scrapped this notional tax credit and the concept of a net dividend. Now, all dividends are received gross, and taxable at 8.75%, 33.75%, or 39.35%, to the extent that they fall into the basic, higher or additional rate bands. The stated aim of the overhaul was to combat ‘tax-motivated incorporation’.
2016 also saw the introduction of a dividend ‘allowance’, which is really a 0% band. The 2022/23 dividend allowance is £2,000 (originally £5,000), and the intention is to ensure investors with modest shareholdings were not impacted.
Then, now and next
To illustrate the impact of the change, consider the final year under the old system — 2015/16. A sole trader with profits of £100,000 would keep just over £66,200 after tax and NI. However, a director shareholder of a single person company would keep just over £71,000 - a saving of almost £5,000.
Fast forward to 2022/23 and a sole trade with the same profits would keep £66,800. The director shareholder would still be better off with just over £68,600, but the saving has been drastically reduced.
Let’s now look ahead to 2023. Currently, there is a single rate of corporation tax of 19%. However, from April 2023, the main rate of corporation tax will increase to 25%. Companies with profits not exceeding £50,000 will continue to use the small profits rate of 19%. Companies with profits in excess of £50,000 will be charged at 25%. However, where profits do not exceed £250,000, marginal relief can be deducted to reduce the effective rate of tax.
The marginal relief is calculated by taking the difference between the chargeable profits and £250,000 and multiplying this by 3/200 (the marginal relief fraction). So, if the chargeable profits were £100,000, the marginal relief available would be 3/200 × £150,000 = £2,250. The effective rate of tax would therefore be 22.75%.
This change will have a significant impact on the decision to incorporate going forward. Let’s look again at the position for a sole trader and a single person company director shareholder following the change. We’ll assume the accounting period falls wholly after 1 April 2023.
The sole trader is in more or less the same position as for 2022/23, keeping just under £67,000 of their profit after tax and NI. That makes sense as sole trade profits are not subject to corporation tax.
However, the director shareholder’s position is affected because the profits after deducting the director salary of £12,570 (the optimum position due to the increase in the primary threshold) fall into the marginal relief band. The corporation tax bill will increase compared to 2022/23, leaving less distributable profits to take as a dividend. Our director shareholder will keep just £67,000, putting them on a par with a sole trader.
The future for incorporation
When considering whether to incorporate following the 2023 rate increase, it is unlikely to be worth doing so from a purely tax-motivated angle, unless it is fairly certain that profits will remain within a fairly narrow band, around £50,000 to £75,000.
However, the tax efficiency could be increased in a number of ways depending on the circumstances. For example, the director shareholder may not require all the profit to be extracted every year. Profits left undrawn as dividends will still be subject to corporation tax of course, but will not be subject to income tax until they are withdrawn. If this takes place in a later year, perhaps when profits are lower, or post-retirement, they could be subject to a lower rate of dividend tax.
The undrawn profits could also be put to use for the company to make investments in its own name. This does not solve the tax efficiency issue, but could increase the distributable profits going forward.
An alternative strategy would be to use the undrawn profits to make pension contributions as the employer. These would be deductible for corporation tax, but of course the downside is that the money is then locked away until pensionable age is reached.
If these options are not suitable, ie, because the director shareholder needs as much money as possible from the company each year, a powerful strategy would be to bring a spouse or civil partner in as a second director shareholder.
This would eliminate secondary class 1 NI contributions, as the employment allowance would then be available. It would also have a drastic effect on the corporation tax and income tax charged.
Firstly, assuming there is no other income, both directors would withdraw a salary, saving corporation tax of up to 25%. Secondly, the income paid out to the individuals would enjoy the benefits of two personal allowances, basic rate bands and dividend allowances.
In fact, returning to our company with profits of £100,000, assuming both directors take a salary of £12,570, the corporation tax bill falls by over £3,000.
Assuming the dividend is split equally, neither director shareholder breaches the higher rate threshold, and the income tax bill is less than £5,000. Overall, the change to a two-person company saves over £12,000, leaving our happy couple with £79,200.
To sum up, the days of the old ‘one-man (or woman) band’ companies may be numbered, but there is certainly still a place for incorporation with tax savings in mind. Obviously, this is subject to future attacks by the government.
Profit extraction for 2022/23
The surprise announcement of the Spring Statement in March 2022 was undoubtedly the decision to increase the NI payment thresholds, including the primary threshold to the level of the income tax personal allowance. However, this has been complicated by the fact that the primary threshold increase takes place from July rather than the start of the year.
The profit extraction strategy often revolves around what level to set the director salary at. In previous years, it has generally been optimal to restrict this to the level of the secondary threshold, unless the employment allowance is available (where a salary equal to the personal allowance is slightly better).
For 2022/23, the optimum salary for a director with no other income outside the salary and dividends will be £11,908 following the change to the primary threshold. If the employment allowance is available, it will be very slightly more efficient to increase this to £12,570, but in practice the difference is minimal.
Caution:
This article is written as a guide. Readers are advised to discuss their individual circumstances and tax position with their accountants and/or tax advisers before taking any further steps.
