Can you save tax by using a company?

The most important difference between the way companies and other businesses are taxed can be summarised as follows:

Sole traders/partners pay income tax on their profits and capital gains tax on their capital gains.

Companies pay corporation tax on both their income and capital gains. In this article we will show you how corporation tax is calculated. Despite all the mumbo-jumbo in tax textbooks, it's actually quite simple. We will also use a number of examples to compare income tax with corporation tax. The differences are potentially enormous. Corporation Tax Rates The taxable profits of a company are calculated in a similar way to a sole trader or partnership. The starting point is 'accounting profit' and amounts are then added or subtracted from this figure to calculate taxable profit. A simple example of how accounting profits differ from taxable profits is in the area of capital expenditure. In the current tax year, which started in April 2012, you can claim a 100% investment allowance for capital spending of up to £25,000. Yet in your accounts you might write off assets over five years, with a 20% allowance in year one. Clearly your taxable profits would then be lower than your accounting profits. Looking at how those profits are taxed, companies, sole traders and partnerships are all subject to higher tax rates as their profits increase. Corporation tax rates are, however, much lower than income tax rates in many cases. There are two 'official' corporation tax rates:

Small profits rate = 20%

Main rate = 24% Companies with taxable profits of £300,000 or less pay 20%, and companies with taxable profits exceeding £1.5 million pay 24%. If profits are between £300,000 and £1.5 million a marginal relief calculation is made. This can be complex but in practice we can say that companies currently pay 25% tax on profits between £300,000 and £1.5 million. Looking at the above table, a company with profits of £1,000 will pay £200 in corporation tax. A company with profits of £300,000 will pay £60,000 in corporation tax. Both will pay tax at 20%. A company with profits of £500,000 will pay 20% tax on the first £300,000 and 25% on the remaining £200,000. The total corporation tax bill will be £110,000 and the company's overall effective tax rate will be 22%: £110,000/£500,000 = 22% A company with profits of £1.5 million will pay 20% tax on the first £300,000 and 25% on the remaining £1.2 million. The total corporation tax bill will be £360,000 and the company's overall effective tax rate will be 24%: £360,000/£1,500,000 = 24% So once profits exceed £1.5 million, you can ignore the 20% and 25% tax rates. All profits are taxed at a single rate of 24%. It doesn't get much easier than this! Future Corporation Tax Changes No changes to the small profits rate have been announced. However, the main rate will fall by another 1% in 2013, and a further 1% in 2014. This means that, from 1st April 2014, corporation tax will be levied at the following rates:

Profits up to £300,000 = 20%

Profits from £300,000 to £1,500,000 = 22.5%

Profits over £1,500,000 = 22% Accounting Periods vs Financial Years A company's accounting period may end on any chosen date, for example 31st December. Corporation tax, on the other hand, operates by reference to 'financial years'. Financial years run from 1st April to 31st March. (This is not to be confused with the tax year for individuals, which runs from 6th April to 5th April.) Financial years are officially described by reference to the calendar year in which they start. Hence, the 2012 financial year is the year commencing on 1st April 2012 and ending on 31st March 2013. Why is this important? For starters, it's often useful to be aware of the official terminology, for example when talking to your accountant or reading HMRC's official documentation. It's may also be important when calculating how much tax your company will pay, especially when corporation tax rates change from one financial year to the next. For example, on 1st April 2012 the main rate of corporation tax fell from 26% to 24%. This means that a company with over £1.5 million of taxable profits, whose accounting period runs from January 2012 to December 2012, will pay corporation tax as follows:

3 months to 31st March 2012 = 26%

9 months to 31st December 2012 = 24% The practical effect is that the company will pay 26% corporation tax on one quarter of its profits and 24% tax on three quarters of its profits -- a total effective tax rate of 24.5%. Companies with profits of £300,000 or less pay corporation tax at the small profits rate. The rate is currently 20% and no changes have been announced for future years. Hence for these companies it is not necessary to calculate two sets of corporation tax. Corporation tax will be payable at a flat rate of 20% on all of the company's profits, even if the accounting period straddles two financial years. Cash Flow Benefits Unlike a company, which is a separate legal entity, all of the profits of a sole trader business are taxed in the hands of the owner (the proprietor). This is an essential point to grasp. The sole trader will pay tax on the taxable profits of the business, irrespective of the amount that is actually taken out of the business as drawings, to pay for living expenses etc. As a general rule, a sole trader's tax bill has to be settled by January 31st following the end of the tax year. A tax year runs from 6th April to the following 5th April. For example, the 2012/13 tax year runs from 6th April 2012 to 5th April 2013. Your tax return filing date depends on whether you file an electronic or paper return. If you file online you can still file at any time up to 31st January following the end of the tax year. If you want to file a paper return you need to file it by 31st October following the end of the tax year. For the 2012/13 tax year this means the filing deadlines are:

Paper return -- 31st October 2013

Electronic return --31st January 2014 Corporation tax is generally paid nine months after the end of the company's accounting period. In comparison, most sole traders have to make two payments on account -- in other words, they have to pay their taxes up front. Payments on account are based on the income tax liability of the previous tax year. The payments on account will be equal amounts, based on the actual income tax liability of the preceding year, less any tax already deducted at source. Example For the 2012/13 tax year Anita, a sole trader, has the following tax bill: Capital gains tax = 10,000 Income tax = 35,000 Less: tax deducted at source = -20,000 Net liability = 25,000 Payments on account for the 2013/2014 tax year will be as follows: Income tax = 35,000 Tax deducted at source = -20,000 Total POA = 15,000 First payment on account due 31st January 2014 = £7,500 Second payment on account due 31st July 2014 = £7,500 A balancing payment is also due on 31st January 2015. This will depend on the actual tax liability for 2013/14 (including any capital gains tax liability), less the payments on account that have already been made. In conclusion, many companies enjoy significant cash flow advantages over many sole traders. Self-Employed Income Tax Rates Sole traders and partners are subject to the same income tax rates as any salary earner or other personal taxpayer. These can be summarised as follows: Income up to £100,000 Most sole traders enjoy a tax-free personal allowance which means the first £8,105 of their profits is tax free. The next £34,370 of profits is subject to basic-rate income tax at 20%. If you add together £8,105 and £34,370 you get £42,475 -- the point where higher-rate income tax at 40% kicks in. (There is also a 10% savings rate but this only applies to savings income such as bank interest and not to earned income.) Income between £100,000 and £116,210 Once your income exceeds £100,000 your £8,105 income tax personal allowance is gradually taken away. It is reduced by £1 for every £2 you earn above £100,000. So once your income reaches £116,210 you will have no personal allowance at all. This is bad news for those earning over £100,000. The personal allowance currently saves you £3,242 in tax if you are a higher-rate taxpayer. It doesn't matter what type of income you earn. Your personal allowance will be withdrawn if you have savings income, business profits, rental income or employment income. Example Bill has earnings of £110,000. His earnings exceed the £100,000 limit by £10,000. This means his personal allowance will be reduced by half this amount (£5,000), leaving him with a personal allowance of £3,105. It's important to note that the £5,000 of income that was tax free will now be taxed at 40%, not 20%. The basic-rate tax band is limited to just £34,370 of income. In summary, Bill pays income tax at the following rates. First £3,105 = 0% Next £34,370 = 20% Next £72,525 = 40% Income Tax vs Corporation Tax So which tax rates are better -- the corporation tax ones outlined in the previous chapter or the personal tax rates discussed above? The best way to compare them is with some examples. Let's say Joe Bloggs Limited has taxable profits of £100,000. The company's tax bill is only £20,000 (£100,000 x 20%). But what if Joe Bloggs is a sole trader? Put £100,000 into the above personal income tax table (the one for income up to £100,000) and you will end up with a tax bill of £29,884. Joe Bloggs Ltd's corporation tax bill is £9,884 lower than Joe Bloggs' income tax bill. Similarly, if Joe Bloggs Limited has profits of £200,000 the company will pay £40,000 in corporation tax. However, if Joe is a sole trader, putting £200,000 into the above personal tax rate table (the one for income over £116,210) produces a tax bill of £78,126. The company pays £38,126 less tax than the sole trader! The table below compares corporation tax and income tax at other profit levels. Note that when profits are less than around £50,000 income tax is actually lower than corporation tax. The £8,105 personal allowance, available to individuals and not companies, significantly lowers the tax charge. At profit levels above £50,000, the 40% income tax rate has already kicked in and the 20% corporation tax rate starts producing a smaller tax bill for the company. The table also shows the big increases in income tax when profits increase from £100,000 to £120,000 (due to the withdrawal of the personal allowance) and when profits go above £150,000, thanks to the 50% additional tax rate. Please note, the Table does not imply that businesses with profits under £50,000 should avoid incorporating. For example, we haven't included the national insurance paid by sole traders or the fact that company owners can extract tax-free salaries that are tax deductible for the company and therefore reduce the company's tax bill.

Corporation Tax vs Income Tax 2012/13
Profits	Corporation tax	Income tax	Saving
£	£	£	£
10,000	2,000	379	-1,621
15,000	3,000	1,379	-1,621
20,000	4,000	2,379	-1,621
25,000	5,000	3,379	-1,621
30,000	6,000	4,379	-1,621
35,000	7,000	5,379	-1,621
40,000	8,000	6,379	-1,621
50,000	10,000	9,884	-116
60,000	12,000	13,884	1,884
70,000	14,000	17,884	3,884
80,000	16,000	21,884	5,884
90,000	18,000	25,884	7,884
100,000	20,000	29,884	9,884
120,000	24,000	41,126	17,126
140,000	28,000	49,126	21,126
160,000	32,000	58,126	26,126
180,000	36,000	68,126	32,126
200,000	40,000	78,126	38,126

For now what we can say is that:

Corporation tax bills can be a lot lower than income tax bills but not at all profit levels.

There's something else that is not immediately apparent from a cursory examination of the Table: The tax savings become proportionately larger as profits increase. The reason for this is that companies with profits below £300,000 pay tax at a flat rate of 20% -- the tax rate does not increase as the amount of profit increases. Most tax systems in the Western world are progressive -- in other words, tax rates go up as income goes up. But in the UK, a company with £300,000 of profits pays tax at the same rate as a company with £1,000 of profits.

What more incentive do you need to grow your business?

With personal tax rates, however, the story is completely different.

As a sole trader, when your business profits exceed £42,475 the extra income you earn is taxed at 40%. When your profits exceed £100,000 your personal allowance is gradually withdrawn and when your profits exceed £150,000 you currently start paying tax at 50%.

This means your overall effective tax rate goes higher and higher as your profits increase. For example, a sole trader earning £50,000 of profits only pays tax at an overall rate of about 20%; a sole trader earning £200,000 pays tax at an overall rate of 39%.

The important thing to note is that:

As profits go up, using a company becomes more and more attractive.

However, as mentioned already, we are not looking at the complete picture yet.

One thing we have ignored is the tax paid by the owners of the company.

For sole traders and partnerships there is no further tax to worry about once income tax and national insurance have been paid on the profits of the business.

However, if company owners want to get their hands on the company's profits they have to pay themselves a dividend or salary. This could result in less tax (in the case of a small tax-free salary) or more tax being paid.

The critical question is: After paying any extra tax, are you still better off using a company? We look at this in more detail in the members only section.