Contractors: Setting Up a Limited Company is not "Tax Efficient"
Posted in Jobs and Recruitment on Wednesday, the 8th of February, 2012.
Over the last few months I've made the transition from full-time employment, to self-employment, and finally to working through my own limited company. If nothing else, this should make my next tax return particularly interesting.
Forming a limited company to invoice through is fairly common practice for contractors, not least because there is a perception that it's more tax efficient to do so. In fact it's more than a perception: it's a widely-held belief, which is repeated time and time again. It's also completely and utterly untrue.
Let's get this straight: for the average contractor there are absolutely no tax savings to be made by forming a limited company.
What's particularly sad is that the accountancy profession does nothing to shatter this illusion: they want your custom, and you really don't need an accountant to fill in a plain old self-assessment tax return, so why would they tell you any different?
How it Works
If you work through a limited company, well, first you find a client and go to work! Next you (or your accountant) invoice for your work, and eventually the money you earn is paid into a company bank account.
Simple enough so far, but now you need to eat and pay the rent, so you need to get at the money you've earned. The usual strategy for contractors working through a limited company is to pay oneself a minimal salary, typically somewhere in the region of £7,475 to £11,000 per annum, thus making the most of your tax-free allowance, and paying minimal income tax.
The remainder of the money is paid as dividends. This seems appealing, because tax on dividends is much lower than income tax. The effective [1] rates for tax year 2011-12 are as follows, for earnings above the tax-free allowance:
Earnings Range | Income Tax | Dividend Tax |
---|---|---|
£0 - £35,000 | 20% | 0% |
£35,001 - £150,000 | 40% | 25% |
over £150,000 | 50% | 36.1% |
Looks compelling, doesn't it? This is exactly the sort of comparison that an accountant will show you when touting for your business. But what they usually neglect to mention is Corporation Tax. This is paid on all profits made by your company, before dividends are paid. For a contractor, those profits are typically your earnings, minus a few scattered expenses, minus that minimal salary you're paying yourself.
Corporation Tax is currently pegged at 20% and, as I mentioned, is removed before dividends are paid. This wipes out exactly the amount of tax savings you thought you were making on your income.
Illustrations
To illustrate that, let's say you earn £40,000 per annum. Assume the current tax-free allowance of £7,475—which absolutely everyone is entitled to—and you're left with taxable earnings of £32,525. Standard income tax would wipe off 20% (£6,505) leaving you £26,020 to enjoy as you see fit. Pay it as dividends, however, and while the dividends are effectively not taxed, Corporation Tax takes off the very same 20%, leaving you with £26,020.
As a further example, imagine you earn £80,000 per annum. After the tax-free allowance of £7,475, you're left with a taxable amount of £72,525. Without a limited company, the income tax on the next £35,000 is 20% (£7,000). Higher-rate income tax on the amount over £42,475 (a remainder of £37,525) would be charged at 40%. That's another £15,010, leaving a total tax bill of £22,010. Check it out for yourself using this handy calculator.
Earn the same amount through a limited company and see what happens. The tax-free allowance is identical, and—just as we saw in the first example—the next £35,000 are taxed identically, via Corporation Tax, at 20% (£7,000). Now, again, you're left with a remaining £37,525 to think about. Corporation Tax continues to apply, and takes 20% (£7,505). The remaining £30,020 dividend is subject to dividend tax at 25%; that's another £7,505 for a total tax outgoing of, you guessed it, £22,010.
So your tax is identical, limited company or not. That's no coincidence: HMRC have actually thought this stuff through.
One final point to add is that dividends and income are not separate buckets: you can't earn a £40k salary and £35k in dividends and avoid the higher rate bands. Which band you're in is based on your combined personal income for the year.
Costs
So the whole story about limited companies being "tax efficient" is a complete myth.
It gets worse, however, because once you choose to "go limited", you're going to be hit by a whole swathe of extra costs. Off the top of my head, these are likely to include:
- Company set-up costs: typically anywhere between £70-£200 + VAT
- Accountancy fees: anywhere between £60-£150 per month + VAT
- Insurance: my combined Public Liability and Professional Indemnity insurance come to about £40 + VAT per month, though that's probably slightly inflated by working in the financial sector, where you typically need a relatively high level of cover
- Business banking fees: these will vary greatly, but for reference, HSBC's fees are available online
You also have to factor in the cost to yourself in time. It probably took me a solid week of paperwork and meetings to get everything set up. That's a week that I could quite literally have spent working and earning money otherwise. The administrative work in simply keeping the company ticking over never goes away, and is fairly onerous too.
So Why Bother?
That's a good question. People set up limited companies day in, day out, so why do they do it?
In my case, my client required it, and similarly, they required the company to be insured as I mentioned above. I believe it gives them some degree of legal comeback if I break things and cost them a fortune.
Another reason you might take this route would be if you are planning for retirement, or to take some years out of work. Since you don't have to take all your dividends out in a single year, you can leave money in the company and draw it down in later years when you are not earning. Get the amounts right, and you can avoid the higher rate tax bands altogether. Suffice to say, this won't be particularly relevant to the average contractor.
Another factor I've glossed over is that of National Insurance. Dividend payments do not incur N.I. liability, so there are savings to be made there. The savings won't be trivial, but at best they'll cover the extra costs involved with running a company, and perhaps go some way towards recompense for the time and effort you'll have to put in.
Conclusions
All in all, there may well be reasons for setting up a limited company, but tax efficiency simply is not one of them. I only wish that accountants could be more open about it up front, and save us all a great deal of confusion and disappointment.
So in terms of some kind of positive advice to ordinary contractors, all I can add is this: if you do genuinely need to start a limited company, you're probably going to need an accountant. You want to choose a good one, but how do you tell?
I would suggest you open by asking them "what are the tax benefits of starting a limited company?" If they imply, or otherwise allow you to believe, that the answer is anything other than "none", find a different accountant.
[1] I describe the rate as "effective" because that's what you pay. The actual system is a needlessly complicated mess of tax credits and deductions, explained by HMRC here.
Posted by Ciaran McNulty on Thursday, the 9th of February, 2012.
That's very interesting, I was certainly under the impression that limited companies were more tax-efficient.
However there are some benefits you've missed:
1. You mention savings, but also a company can contribute to your pension without any tax being incurred on that amount at all. This is also before corporation tax so effectively you can pay into your pension with no tax at all.
2. The company can buy assets that you can then use as the sole employee - these are costs before corporation tax.
3. Limited liability - if the company incurs massive debts you can liquidate it