What are the Tax differences between a Sole Trader and a Limited Company?
When you’re running your own business the decision to be a sole trader or limited company can have a major impact on your tax bill. It is important to understand the tax differences between these two business structures to help make an informed decision.
As a sole trader you will pay your tax on profits through self-assessment at the end of the tax year. National Insurance Contributions and Income Tax will be collected by HMRC on the profit. For 2018-19 Class 2 contributions are calculated at £2.95 a week if your profit is £6,205 or more for the year. Class 4 contributions are calculated at 9% of your profit between £8,424 and £46,350, and 2% of any profits over this amount. You will also be liable to pay Income Tax at 20% (basic rate) on any profits once your personal allowance for the year of £11,850 is used up; this will increase to 40% (higher rate) on any income over £46,351, and 45% (additional rate) on any income over £150,000.
As a limited company you must prepare a Company Tax Return, where declared profits will be charged corporation tax at 19%. However, this will not be subject to National Insurance Contributions or Income Tax. As a limited company is a separate legal identity to yourself, to permanently take money out of the company for personal use you will pay yourself in the form of salary and dividends.
A salary you draw from the company is decided by yourself and will be deducted from the company’s corporation tax bill. If you have not received any other income during the tax year (e.g. salary from another company, rental income) then you can pay yourself £8,424 without having to pay any National Insurance Contributions, and £11,850 without paying any Income Tax.
Once the salary has been deducted your remaining income can be paid in the form of dividends. It is important to note that dividends will not be deducted from you Corporation Tax bill, however income on dividends are taxed at a considerably lower rate as follows:
- Basic rate: 7.5%
- Higher Rate: 32.5%
- Additional Rate: 38.1%
Furthermore, there is a £2,000 dividend allowance and there will be no National Insurance Contributions payable on your dividend income. When analysing these factors in comparison to the Income Tax rates and National Insurance Contribution charged to a Sole Trader, operating as a Limited Company can result in a much smaller tax bill.
What is the best business structure for you?
The higher your profits the more you should consider running as a limited company to take advantage of the lower tax rate for dividends. Furthermore, if your income fluctuates year on year you can smooth out your taxable income and prevent the higher levels of income tax you would pay in high profit years as a Sole Trader. However, whether you should run your business as a Sole Trader or Limited Company depends a lot on your current business situation. This decision will not just affect your tax bill, so ensure you understand the ins and outs of both business structures before making a decision.