In this article, we look at the tax advantages of operating via a limited company, and drawing down income in the form of dividends as well as salary.
Tax advantages of limited companies
The most tax efficient way to draw down the profits you accumulate in your company is via a small salary and the rest of the income distributed as dividends.
Dividends are not subject to National Insurance Contributions (NICs) or PAYE (income tax).
Instead, you pay a fixed rate dividend tax according to the tax band you fall into (basic, higher, or additional). However, from April 2016, dividends will be taxed at a higher rate, which will reduce the tax efficiency of trading via a limited company.
In addition, by paying yourself a modest salary, you will only pay a small amount of employers’ and employees’ NICs. If your salary falls below the NIC threshold, you won’t attract any NIC liability at all.
For some limited companies, particularly those providing professional services (such as contractrors), these tax advantages are significantly reduced if your contracts are caught by the IR35 rules.
Limited company owners who are caught by the IR35 rules will pay themselves a ‘deemed salary’ subject to standard PAYE and NIC rules, following a 5% flat allowance to cover the costs of running the company.
Flat Rate VAT scheme
You may decide to choose to join the Flat Rate VAT scheme rather than the standard VAT scheme.
Instead of accounting for VAT on each transaction, you apply a flat rate percentage to your company turnover. For many ‘knowledge professionals’ (such as accountants, architects, IT contractors and lawyers), this rate is 14.5%. You are likely to be better off assuming you don’t make a lot of purchases via the company.
You are also allowed to reclaim VAT on one single transaction of £2,000 or over.
In your first year on the flat rate scheme, you can also take advantage of a 1% reduction in the percentage used. For those working in the industries mentioned above, this reduces the percentage to 13.5%.
Unlike sole traders and members of a partnership, if you are a limited company director, you have far more control over how you manage your finances.
You can decide how much to pay yourself, and when to declare dividends. For example, you may want to delay declaring dividends until a future tax year, in order to minimise your higher rate tax liability.
You may also decide to involve a spouse or partner in the business, as a salaried employee or shareholder which can be advantageous for tax reasons.
You should always consult your accountant on tax planning, and particularly how best to structure the shareholdings in the company.
Although the tax advantages of running a limited company are reason enough to incorporate, there are many other benefits to forming a company. We will explore these issues in future FAQs.