Over the years up to April 2004, the tax charge on incorporated entities was considerably lowered. These low rates (compared to income tax rates) coupled with substantial NIC savings, encouraged increasing numbers of traders to incorporate and run their business as a company, extracting most of the profit as dividends.

Due to the tax lost to the Treasury by such incorporations, the 2004 budget introduced an additional requirement that profits which are distributed (dividends) must have suffered corporation tax at 19%. This additional tax charge on distributions clawed back some of the tax lost under the previously very benign regime.

However, even with the new 19% rate there could still have been substantial tax and NIC savings available if your business were incorporated, rather than run as a sole trade.

The 2006 Budget dispensed with the 0% starting rate and all profits up to £300,000 were charged at 19%.

The 2007 Budget increases the small companies rate to:

20% for 2007/08
21% for 2008/09
22% for 2009/10

with a reduction in the basic rate of income tax to 20% from 6 April 2008. Whether to incorporate will need careful consideration. There should still be savings to be made but the gap is likely to be smaller.

Rate of Corporation Tax for 2007/08

Examples of corporation tax payable, after taking a salary equal to the personal allowance, are as follows:

For a company that makes distributions, the tax payable will now be the same as above:

[N.B. Dividends can only be paid up to the level of distributable reserves, which takes into account the salary payment and the tax payable. A 'distribution' of the whole of the profit figures above would be an 'over-distribution' and would be illegal, and annullable. The maximum dividend payable is shown in each case.]

Compare these figures with the profits from trading as a sole trader:

So it can be seen that even if the distributions are made there are still substantial savings to be made (albeit not as substantial as previously). On the above level of distribution the savings made by incorporating a sole trade are:

In the case of a dividend of £31,820 the savings are reduced by £170 personal higher rate tax that would be due.

National Insurance

There are currently no NICs on dividends. All NICs can be avoided by incorporation, taking a small salary up to the threshold at which NI is payable and taking any balance as dividends.

Pension Contributions

If you wish to make pension contributions of up to £3,600 per annum (gross) these can be made without drawing a salary. Contributions over this amount will require a salary if tax relief is to be claimed on the contributions, unless you have other self-employed income.

Partnerships

The savings made by individual partners when a partnership is incorporated will depend on the circumstances of those partners.

If you currently trade as a husband and wife partnership, the savings at higher profit levels are likely to be greater, due to the availability of two personal allowances and lower and basic tax bandings (but please note that availability may be restricted in cases where one director/employee/shareholder spouse is less active in the company).

Exceptions

There are, of course, other factors to be considered in deciding whether or not to incorporate. For example, you may be caught by the IR35 legislation for personal service companies (see our Quick Guide to IR35).

You may find the additional paperwork involved in running a limited company too much of a burden.

There may be issues concerning the cessation of your sole tradership which need to be considered.

And, of course, having reversed some of the previous tax benefits, there may be further developments in the future such that the tax suffered by incorporated entities and the directors or shareholders is again increased.

Please note: This guide is intended to provide basic information only. Where specific advice is required, we recommend that you seek proper professional help; either from this firm or other suitably qualified person or practice.