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In the November 2021 issue of Counsel, I looked at three reasons why you might want to look at incorporating. This article goes into more detail with some worked examples which show how incorporating can be used to pay lower rates of tax in retirement.
The concept is straightforward. When trading as a sole trader you are taxed as an individual on your taxable profits, regardless as to whether you have drawn this from the business or not. Trading as a limited company will result in the company paying corporation tax (currently 19% but due to rise) on all the taxable profits, whereas as an individual you are only taxed on the income extracted from the company (usually a mixture of salary and dividends). By leaving some retained profits in the company, these can be paid out to the individual as dividends after the company has ceased trading (ie, after you have retired) at a lower rate of tax. They could also have significantly increased in value if invested by the company over this time period.
Here are three worked scenarios showing how this might work, what the tax savings would be and using the tax rates for the year ended 31 March 2022:
1. Scenario A, where taxable profits are £150,000 but only £100,000 of profit is extracted.
2. Scenario B, where taxable profits are £300,000 but only £200,000 of profit is extracted.
3. Scenario C, where taxable profits are £600,000 but only £400,000 of profit is extracted.
A sole trader with a taxable profit of £150,000 would have a total tax liability for the year of £58,277. Cash available to the individual after tax is £91,723. Therefore, 39% of the taxable profits is required to pay the tax liability.
After a basic salary of £8,832, the company has corporation tax at 19% to pay on the remaining £141,168, being £26,822. Dividends of £91,168 are paid so the total personal taxable income is £100,000. A further personal tax liability of £18,840 will also be due. This means the total tax paid is £45,662. The company has retained profits carried forward of £23,178 which can be extracted at a later date (see below). Cash immediately available to the individual after tax is £81,160.
The examples below show how these retained profits can be extracted at either a 5% or 19% rate of tax in future years. At 5%, £1,159 of further tax will be paid. This results in a total tax paid of £46,821 and total cash available to the individual after tax of £103,179. At 19%, £4,404 of further tax will be paid. This results in a total tax paid of £50,066 and total cash available to the individual after tax of £99,934. Both scenarios offer a lower overall tax burden than the sole trader tax liability of £58,277.
A sole trader with a taxable profit of £300,000 would have a total tax liability for the year of £128,776. Cash available to the individual after tax is £171,224. Therefore, 43% of the taxable profits is required to pay the tax liability.
After a basic salary of £8,832, the company has corporation tax at 19% to pay on the remaining £291,168, being £55,322. Dividends of £191,168 paid so that total personal taxable income is £200,000. A further personal tax liability of £59,329 will also be due. This means the total tax paid is £114,651 and the company has retained profits carried forward of £44,678 which can be extracted at a later date (see below). Cash immediately available to the individual after tax is £140,671.
The examples below show how these retained profits can be extracted at either a 5% or 19% rate of tax in future years. At 5%, £2,234 of further tax will be paid. This results in a total tax paid of £116,885 and total cash available to the individual after tax of £183,115. At 19%, £8,489 of further tax will be paid. This results in a total tax paid of £123,140 and total cash available to the individual after tax of £176,860. Both scenarios offer a lower overall tax burden than the sole trader tax liability of £128,776.
A sole trader with a taxable profit of £600,000 would have a total tax liability for the year of £269,776. Cash available to the individual after tax is £330,224. Therefore, 45% of the taxable profits is required to pay the tax liability.
After a basic salary of £8,832, the company has corporation tax at 19% to pay on the remaining £591,168, being £112,322. Dividends of £391,168 paid so that total personal taxable income is £400,000. A further personal tax liability of £135,529 will also be due. This means the total tax paid is £247,851 and the company has retained profits carried forward of £87,678, which can be extracted at a later date (see below). Cash immediately available to the individual after tax is £264,471.
The examples below show how these retained profits can be extracted at either a 5% or 19% rate of tax in future years. At 5%, £4,384 of further tax will be paid. This results in a total tax paid of £252,235 and total cash available to the individual after tax of £347,765. At 19%, £16,659 of further tax will be paid. This results in a total tax paid of £264,510 and total cash available to the individual after tax of £335,490. Both scenarios offer a lower overall tax burden than the sole trader tax liability of £269,776.
On retirement, the company would cease to trade but would have accumulated retained profits that it can pay out as dividends. Obviously, the amount of accumulated retained profits depends on how much is retained each year and for how many years you have been incorporated and able to do this.
Therefore, instead of taking a pension at the outset of retirement, these retained profits can be paid out as dividend income instead (or potentially alongside) of a pension. You could choose to take your pension lump sum (up to 25% of your pension pot), which is tax free, or look to defer this whilst paying these dividends. For specific pension planning advice in this area, you will need to talk to a financial planner.
If an annual dividend of £50,000 is taken then this is comfortably within the basic tax band, paying tax at 7.5% on the dividend income after your personal allowance and the £2,000 dividend allowance. The tax liability each year would be £2,657, a tax rate of just over 5% per year.
If an annual dividend of £100,000 is taken, then part of this would be taxed within the basic tax band at 7.5% on the dividend income after your personal allowance and the £2,000 dividend allowance and part in the higher rate band at 32.5%. The tax liability each year would be £18,840, a rate of almost 19% per year.
Both of the above examples are calculated under the assumption that no other income is received in these tax years which might not be the case, certainly if a (state) pension is also being received.
The lifetime pension allowance is currently £1,073,100 and is a cumulative amount over all the pension schemes you have.
If you exceed your lifetime pension allowance, you will have to pay tax on the excess amount.
If you are in danger of exceeding your lifetime allowance, then incorporating and using the above process could be a way of saving further income for retirement.
Please note that if you are unsure of how much of your lifetime pension allowance you have used, you should be able to check this with your pension provider(s).
Please note that the above examples have used the tax rates for the tax year to 5 April 2022. It is known that certain tax rates are going to increase including national insurance rates (which will impact sole traders), corporation tax rates and dividend rates (which will impact the limited company tax rates and related profit extraction).
This article contains some of the important considerations but every individual’s personal circumstances are different and there might be further considerations not mentioned here. 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 Limited, 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
In the November 2021 issue of Counsel, I looked at three reasons why you might want to look at incorporating. This article goes into more detail with some worked examples which show how incorporating can be used to pay lower rates of tax in retirement.
The concept is straightforward. When trading as a sole trader you are taxed as an individual on your taxable profits, regardless as to whether you have drawn this from the business or not. Trading as a limited company will result in the company paying corporation tax (currently 19% but due to rise) on all the taxable profits, whereas as an individual you are only taxed on the income extracted from the company (usually a mixture of salary and dividends). By leaving some retained profits in the company, these can be paid out to the individual as dividends after the company has ceased trading (ie, after you have retired) at a lower rate of tax. They could also have significantly increased in value if invested by the company over this time period.
Here are three worked scenarios showing how this might work, what the tax savings would be and using the tax rates for the year ended 31 March 2022:
1. Scenario A, where taxable profits are £150,000 but only £100,000 of profit is extracted.
2. Scenario B, where taxable profits are £300,000 but only £200,000 of profit is extracted.
3. Scenario C, where taxable profits are £600,000 but only £400,000 of profit is extracted.
A sole trader with a taxable profit of £150,000 would have a total tax liability for the year of £58,277. Cash available to the individual after tax is £91,723. Therefore, 39% of the taxable profits is required to pay the tax liability.
After a basic salary of £8,832, the company has corporation tax at 19% to pay on the remaining £141,168, being £26,822. Dividends of £91,168 are paid so the total personal taxable income is £100,000. A further personal tax liability of £18,840 will also be due. This means the total tax paid is £45,662. The company has retained profits carried forward of £23,178 which can be extracted at a later date (see below). Cash immediately available to the individual after tax is £81,160.
The examples below show how these retained profits can be extracted at either a 5% or 19% rate of tax in future years. At 5%, £1,159 of further tax will be paid. This results in a total tax paid of £46,821 and total cash available to the individual after tax of £103,179. At 19%, £4,404 of further tax will be paid. This results in a total tax paid of £50,066 and total cash available to the individual after tax of £99,934. Both scenarios offer a lower overall tax burden than the sole trader tax liability of £58,277.
A sole trader with a taxable profit of £300,000 would have a total tax liability for the year of £128,776. Cash available to the individual after tax is £171,224. Therefore, 43% of the taxable profits is required to pay the tax liability.
After a basic salary of £8,832, the company has corporation tax at 19% to pay on the remaining £291,168, being £55,322. Dividends of £191,168 paid so that total personal taxable income is £200,000. A further personal tax liability of £59,329 will also be due. This means the total tax paid is £114,651 and the company has retained profits carried forward of £44,678 which can be extracted at a later date (see below). Cash immediately available to the individual after tax is £140,671.
The examples below show how these retained profits can be extracted at either a 5% or 19% rate of tax in future years. At 5%, £2,234 of further tax will be paid. This results in a total tax paid of £116,885 and total cash available to the individual after tax of £183,115. At 19%, £8,489 of further tax will be paid. This results in a total tax paid of £123,140 and total cash available to the individual after tax of £176,860. Both scenarios offer a lower overall tax burden than the sole trader tax liability of £128,776.
A sole trader with a taxable profit of £600,000 would have a total tax liability for the year of £269,776. Cash available to the individual after tax is £330,224. Therefore, 45% of the taxable profits is required to pay the tax liability.
After a basic salary of £8,832, the company has corporation tax at 19% to pay on the remaining £591,168, being £112,322. Dividends of £391,168 paid so that total personal taxable income is £400,000. A further personal tax liability of £135,529 will also be due. This means the total tax paid is £247,851 and the company has retained profits carried forward of £87,678, which can be extracted at a later date (see below). Cash immediately available to the individual after tax is £264,471.
The examples below show how these retained profits can be extracted at either a 5% or 19% rate of tax in future years. At 5%, £4,384 of further tax will be paid. This results in a total tax paid of £252,235 and total cash available to the individual after tax of £347,765. At 19%, £16,659 of further tax will be paid. This results in a total tax paid of £264,510 and total cash available to the individual after tax of £335,490. Both scenarios offer a lower overall tax burden than the sole trader tax liability of £269,776.
On retirement, the company would cease to trade but would have accumulated retained profits that it can pay out as dividends. Obviously, the amount of accumulated retained profits depends on how much is retained each year and for how many years you have been incorporated and able to do this.
Therefore, instead of taking a pension at the outset of retirement, these retained profits can be paid out as dividend income instead (or potentially alongside) of a pension. You could choose to take your pension lump sum (up to 25% of your pension pot), which is tax free, or look to defer this whilst paying these dividends. For specific pension planning advice in this area, you will need to talk to a financial planner.
If an annual dividend of £50,000 is taken then this is comfortably within the basic tax band, paying tax at 7.5% on the dividend income after your personal allowance and the £2,000 dividend allowance. The tax liability each year would be £2,657, a tax rate of just over 5% per year.
If an annual dividend of £100,000 is taken, then part of this would be taxed within the basic tax band at 7.5% on the dividend income after your personal allowance and the £2,000 dividend allowance and part in the higher rate band at 32.5%. The tax liability each year would be £18,840, a rate of almost 19% per year.
Both of the above examples are calculated under the assumption that no other income is received in these tax years which might not be the case, certainly if a (state) pension is also being received.
The lifetime pension allowance is currently £1,073,100 and is a cumulative amount over all the pension schemes you have.
If you exceed your lifetime pension allowance, you will have to pay tax on the excess amount.
If you are in danger of exceeding your lifetime allowance, then incorporating and using the above process could be a way of saving further income for retirement.
Please note that if you are unsure of how much of your lifetime pension allowance you have used, you should be able to check this with your pension provider(s).
Please note that the above examples have used the tax rates for the tax year to 5 April 2022. It is known that certain tax rates are going to increase including national insurance rates (which will impact sole traders), corporation tax rates and dividend rates (which will impact the limited company tax rates and related profit extraction).
This article contains some of the important considerations but every individual’s personal circumstances are different and there might be further considerations not mentioned here. 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 Limited, 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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