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One of the key benefits of trading through a limited company over a sole trader is the ability to manage your personal taxable profits. This article discusses the the following three reasons you might look at incorporating:
The main driver for this is that there are various personal tax thresholds where the rate of tax you pay increases; moving from a basic rate taxpayer (20%) to a higher rate (40%) taxpayer as your taxable income goes above £50,270; when your taxable income goes above £100,000 you lose your personal allowance (£1 lost for every £2 over) and pay an effective rate of 60% tax on taxable profits between £100,001 and £125,140; and once you pass £150,000 of taxable income you become an additional rate taxpayer and pay tax at 45%.
By trading through a limited company, the amount of taxable income an individual withdraws from the company can be limited to ensure that these various tax thresholds are not breached. For example, a sole trader with taxable earnings of £250,000 will pay tax on this amount regardless of whether they have drawn all those funds from the business or not. However, if only £100,000 of income is withdrawn (ie needed personally) then a limited company allows you to minimise the tax bill by only paying personal tax on this amount withdrawn. The standard approach in a limited company is to take a low salary of £8,844 and then top up with dividends. The first £2,000 of dividends are tax-free, then a basic rate dividend tax rate of 7.5% (soon to increase to 8.75%) to £50,270, from this to £100,000 is taxed at higher rate dividend tax of 32.5% (soon to increase to 33.75%), then 38.1% (soon to increase to 39.35%) for taxable income over £150,000. Please note that in addition to the above personal tax paid, a limited company also pays corporation tax (currently 19% but set to rise by a sliding scale to 25%).
The second reason you might want to look at incorporating relates to retirement planning. The first two examples below relate to pension planning; the third is much more general and is worth considering for anyone who is planning ahead to retirement.
The starting point is that individuals can make gross pension contributions of up to £40,000 (£32,000 net contributions) per tax year without incurring a tax charge. Once your ‘threshold income’ (taxable income less pension contributions) exceeds £200,000, you must consider whether your ‘adjusted income’ (taxable income plus pension contributions) exceeds £240,000. If it does, the amount of annual allowance is restricted, potentially to a minimum of £4,000. Basically, for every £2 earned over £240,000, the annual allowance decreases by £1, with a maximum reduction of £36,000 when your adjusted income exceeds £312,000. (The definitions of ‘threshold income’ and ‘adjusted income’ have been simplified for the purpose of this article.) The tax charge is at your marginal rate of tax, which will be 45% with earnings in excess of £150,000. Note that tax relief at the marginal rate can be claimed on gross personal pension contributions up to 100% of relevant earnings in a tax year.
This simplification ignores unused pension contributions brought forward from the previous three years, which can be used to increase the annual allowance for the current year to avoid or reduce a tax charge.
Once you have maximised your lifetime pension allowance – which is currently £1,073,100 – there are additional tax charges at your marginal tax rate (20%/40%/45%) on making further pension contributions and also further tax charges (between 25% and 55%) on the remaining balance when the pension is withdrawn.
This will be looked at in greater detail in a future article, along with worked examples. In short, you can retain profits within the limited company to pay out as dividends as part of your retirement planning, before you start drawing down on your pension.
Generally, the above idea of looking to retain profits within the limited company to pay out as dividends as part of your retirement planning, either before or as you start drawing down on your pension, can be used regardless of whether you have maximised your lifetime pension allowance.
There is currently a basis period reform consultation that proposes to align all sole trader year-ends to between 31 March and 5 April. Although this also proposes a five-year smoothing process, there will still be a catching up exercise where up to an additional 11 months of taxable income (for 30 April year-ends) becomes taxable.
Regardless as to whether this does come into legislation, there is still a potential problem for those coming to retirement with a 30 April year-end as there can be considerable tax payable in your final year. There is a worked example of this in RWB’s Barristers’ Booklet explaining the tax ‘problem’ (see: bit.ly/3pAYTbl).
While moving your year-end might help with the second point, incorporating could help with either point.
Limited companies cannot use the cash basis to prepare their accounts. A sole trader can use the cash basis so long as they meet the requirements. Put simply, cash basis accounting is a straightforward way of working out the tax payable, based solely on income received and expenses paid. There is no need to calculate debtors and creditors at the year-end, nor estimate accruals and prepayments. Careful consideration needs to be given to this as barristers’ debtors can be extremely large. Furthermore, there can be misunderstanding when calculating bad debts and contingency fees, meaning more potential for the tax figures to be wrong if investigated by HMRC.
There are different treatments of capital assets, such as cars and phones, between a sole trader and a limited company. A phone is fully allowable and without any benefit in kind if supplied through a limited company, whereas an apportionment between personal and business use is required for a sole trader. Brand new electric (0% emission) cars have 100% first-year allowance for capital allowances purposes and very low benefit in kind charge if a car is provided through a limited company – making this very attractive. A sole trader in the same circumstance would also get this allowance but would be restricted by having to apportion between personal and business use. However, a high CO2 emission car provided by a company to an employee would be significantly taxed (most taxpayers would be better advised to buy the car personally and claim mileage to the company) whereas it would not be as highly taxed if purchased as a sole trader.
This can take some time, certainly longer than if you just registered the company for a new VAT number. Without planning, this can cause additional problems when starting to invoice from the new limited company.
Before you incorporate you will have to get authorisation from the Bar Standards Board. This can, and often does, take a few months. You will also need to ensure that your professional indemnity insurance is amended accordingly, as it will need to provide cover for your past sole trade as well as the new limited company.
There is also the need to have a service contract drawn as it will be the new limited company which is providing legal services to clients.
Finally, it is worth mentioning that you will still have to prepare and file a personal tax return with HMRC, but also have statutory limited company accounts prepared and filed with Companies House, and a corporation tax return prepared and filed with HMRC. This is generally a little more expensive than having an accountant prepare your sole trader accounts and personal tax return.
This article contains some of the important considerations but every individual’s personal circumstances are different and there might be further considerations not mentioned in this article. Therefore, it is important to seek professional advice from an accountant if you are looking to incorporate. This article is provided without any acceptance by RWB CA Ltd, or any of its staff, of any responsibility whatsoever and any use you wish to make of the information is therefore entirely at your own risk.
Nick Bonnello is the Managing Director of RWB Chartered Accountants and heads up the specialist Barrister Tax and Accounts team. For further details please go to: www.rwbca.co.uk/our-services/barristers
One of the key benefits of trading through a limited company over a sole trader is the ability to manage your personal taxable profits. This article discusses the the following three reasons you might look at incorporating:
The main driver for this is that there are various personal tax thresholds where the rate of tax you pay increases; moving from a basic rate taxpayer (20%) to a higher rate (40%) taxpayer as your taxable income goes above £50,270; when your taxable income goes above £100,000 you lose your personal allowance (£1 lost for every £2 over) and pay an effective rate of 60% tax on taxable profits between £100,001 and £125,140; and once you pass £150,000 of taxable income you become an additional rate taxpayer and pay tax at 45%.
By trading through a limited company, the amount of taxable income an individual withdraws from the company can be limited to ensure that these various tax thresholds are not breached. For example, a sole trader with taxable earnings of £250,000 will pay tax on this amount regardless of whether they have drawn all those funds from the business or not. However, if only £100,000 of income is withdrawn (ie needed personally) then a limited company allows you to minimise the tax bill by only paying personal tax on this amount withdrawn. The standard approach in a limited company is to take a low salary of £8,844 and then top up with dividends. The first £2,000 of dividends are tax-free, then a basic rate dividend tax rate of 7.5% (soon to increase to 8.75%) to £50,270, from this to £100,000 is taxed at higher rate dividend tax of 32.5% (soon to increase to 33.75%), then 38.1% (soon to increase to 39.35%) for taxable income over £150,000. Please note that in addition to the above personal tax paid, a limited company also pays corporation tax (currently 19% but set to rise by a sliding scale to 25%).
The second reason you might want to look at incorporating relates to retirement planning. The first two examples below relate to pension planning; the third is much more general and is worth considering for anyone who is planning ahead to retirement.
The starting point is that individuals can make gross pension contributions of up to £40,000 (£32,000 net contributions) per tax year without incurring a tax charge. Once your ‘threshold income’ (taxable income less pension contributions) exceeds £200,000, you must consider whether your ‘adjusted income’ (taxable income plus pension contributions) exceeds £240,000. If it does, the amount of annual allowance is restricted, potentially to a minimum of £4,000. Basically, for every £2 earned over £240,000, the annual allowance decreases by £1, with a maximum reduction of £36,000 when your adjusted income exceeds £312,000. (The definitions of ‘threshold income’ and ‘adjusted income’ have been simplified for the purpose of this article.) The tax charge is at your marginal rate of tax, which will be 45% with earnings in excess of £150,000. Note that tax relief at the marginal rate can be claimed on gross personal pension contributions up to 100% of relevant earnings in a tax year.
This simplification ignores unused pension contributions brought forward from the previous three years, which can be used to increase the annual allowance for the current year to avoid or reduce a tax charge.
Once you have maximised your lifetime pension allowance – which is currently £1,073,100 – there are additional tax charges at your marginal tax rate (20%/40%/45%) on making further pension contributions and also further tax charges (between 25% and 55%) on the remaining balance when the pension is withdrawn.
This will be looked at in greater detail in a future article, along with worked examples. In short, you can retain profits within the limited company to pay out as dividends as part of your retirement planning, before you start drawing down on your pension.
Generally, the above idea of looking to retain profits within the limited company to pay out as dividends as part of your retirement planning, either before or as you start drawing down on your pension, can be used regardless of whether you have maximised your lifetime pension allowance.
There is currently a basis period reform consultation that proposes to align all sole trader year-ends to between 31 March and 5 April. Although this also proposes a five-year smoothing process, there will still be a catching up exercise where up to an additional 11 months of taxable income (for 30 April year-ends) becomes taxable.
Regardless as to whether this does come into legislation, there is still a potential problem for those coming to retirement with a 30 April year-end as there can be considerable tax payable in your final year. There is a worked example of this in RWB’s Barristers’ Booklet explaining the tax ‘problem’ (see: bit.ly/3pAYTbl).
While moving your year-end might help with the second point, incorporating could help with either point.
Limited companies cannot use the cash basis to prepare their accounts. A sole trader can use the cash basis so long as they meet the requirements. Put simply, cash basis accounting is a straightforward way of working out the tax payable, based solely on income received and expenses paid. There is no need to calculate debtors and creditors at the year-end, nor estimate accruals and prepayments. Careful consideration needs to be given to this as barristers’ debtors can be extremely large. Furthermore, there can be misunderstanding when calculating bad debts and contingency fees, meaning more potential for the tax figures to be wrong if investigated by HMRC.
There are different treatments of capital assets, such as cars and phones, between a sole trader and a limited company. A phone is fully allowable and without any benefit in kind if supplied through a limited company, whereas an apportionment between personal and business use is required for a sole trader. Brand new electric (0% emission) cars have 100% first-year allowance for capital allowances purposes and very low benefit in kind charge if a car is provided through a limited company – making this very attractive. A sole trader in the same circumstance would also get this allowance but would be restricted by having to apportion between personal and business use. However, a high CO2 emission car provided by a company to an employee would be significantly taxed (most taxpayers would be better advised to buy the car personally and claim mileage to the company) whereas it would not be as highly taxed if purchased as a sole trader.
This can take some time, certainly longer than if you just registered the company for a new VAT number. Without planning, this can cause additional problems when starting to invoice from the new limited company.
Before you incorporate you will have to get authorisation from the Bar Standards Board. This can, and often does, take a few months. You will also need to ensure that your professional indemnity insurance is amended accordingly, as it will need to provide cover for your past sole trade as well as the new limited company.
There is also the need to have a service contract drawn as it will be the new limited company which is providing legal services to clients.
Finally, it is worth mentioning that you will still have to prepare and file a personal tax return with HMRC, but also have statutory limited company accounts prepared and filed with Companies House, and a corporation tax return prepared and filed with HMRC. This is generally a little more expensive than having an accountant prepare your sole trader accounts and personal tax return.
This article contains some of the important considerations but every individual’s personal circumstances are different and there might be further considerations not mentioned in this article. Therefore, it is important to seek professional advice from an accountant if you are looking to incorporate. This article is provided without any acceptance by RWB CA Ltd, or any of its staff, of any responsibility whatsoever and any use you wish to make of the information is therefore entirely at your own risk.
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