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.

Comments

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

Posted by Simon Harris on Thursday, the 9th of February, 2012.

Cheers, Ciaran. Some good points, but as far as I'm aware:

1. Anybody, even a PAYE employee, can pay into a pension from their pre-tax earnings. I believe you are taxed when your pension pays out, regardless.

2. As self-employed/sole trader you can buy assets from your pre-tax earnings - you don't need a limited company to do that.

3. True, I didn't mention that aspect, but then it's not really tax-related, and that situation probably doesn't apply to most contractors.

Posted by Paul Green on Thursday, the 9th of February, 2012.

Posted by Ida Rolek on Thursday, the 9th of February, 2012.

Not even a single word about national insurance (you have to pay it when you get a salary but not when you get a dividend).

Or about VAT (if you are a VAT registered company, for IT contractors you can be on Flat Rate Schema which is simple and gives you couple % more).

Or about costs that make your corporation tax lower (buy a laptop, buy a printer, buy some stationery and books, cover travel expenses, food, postage, company costs = lower corporation tax).

Posted by Ida Rolek on Thursday, the 9th of February, 2012.

Oh, and on top of that:
if you are a contractor and don't want to setup your own company, you have to use umbrella company.
In that case it charges you for employee and employer NI and its own fee.

If you don't want to be contractor, you don't get high day rates.

Out of three options:
- contractor with umbrella;
- contractor with own limited company;
- permanent employee

having a limited company is the one that gives you most money in the end of day.

ida

Posted by Ciaran McNulty on Thursday, the 9th of February, 2012.

@Simon on the issue of assets I was under the impression a LLC had less scrutiny over how work related the items were, but that is probably incorrect now I think about it.

Posted by Simon Harris on Thursday, the 9th of February, 2012.

Thanks for contributing, chaps. You know, one of my reasons for posting this was that I'm really quite keen to be proven wrong, since I'm committed to this route for the time being anyway. I'll address a few points...

@Paul

> Class4 NIC would be payable on the profit

Sorry for being a bit slow, but I don't fully understand. Are you saying that there's another cost that I haven't considered?

> you would need to take out PI insurance however you are set up

I'll grant that it may be wise. I managed fine without it last year, so clearly one doesn't "need" to, but I don't know what the risks might be.

@Ida

> Not even a single word about national insurance

I'm afraid that this rather proves that you didn't fully read the post.

> Or about VAT

No, fair point, that's a whole other subject and one I'm ill-equipped to do justice to. Plus, the FRS VAT trick is just that, it's not a genuine tax benefit. Still, I'm registered for it, and it'll be interesting to see how it works out for me.

> Or about costs that make your corporation tax lower (buy a laptop ...)

Firstly, there is no way in the world that you can suggest that buying more stuff will make me financially better off. Secondly, a self-employed/sole trader arrangement allows you to buy the very same items from your pre-tax earnings, as I mention to Ciaran above.

> if you are a contractor and don't want to setup your own company, you have to
> use umbrella company

This simply isn't true, is it? I was contracting last year as a sole trader, and that did not require an umbrella company.

Posted by Ian on Tuesday, the 14th of February, 2012.

You might take a look at

http://www.uktaxcalculators.co.uk/dividend-vs-salary.php

for a quick and easy calculator/comparison

Posted by Simon Harris on Tuesday, the 14th of February, 2012.

Thanks, Ian - good link. I've seen that before though, and it does seem to confirm that the only real difference is NI, plus a few miscellaneous pounds which sadly aren't well-explained.

Incidentally the middle calculation, "full director's salary", seems largely irrelevant - I don't know why anyone would take that route (IR35?)

Posted by just me on Tuesday, the 14th of February, 2012.

50k profits in minimal wage + divs = ~40k
Effective rate 20%

50k profits distributed via PAYE= ~32k, effective rate 36%.

The whole premise of your post is utter nonsense.

Posted by Simon Harris on Tuesday, the 14th of February, 2012.

Thanks for stopping by, Richard ("just me"). I realise that you may have a vested interest in believing contrary to my demonstrated figures, but can you show your working at all?

Your numbers don't correspond to those generated by the calculator that Ian linked to, so somebody is wrong.

[Edit] Apologies if it's not blindingly clear, but I should also remind you that I'm not comparing PAYE vs. limited company here - that's apples and oranges. As the title states, I'm talking specifically to contractors, and discussing whether forming a limited company is worth it for tax reasons alone.

Posted by Ian on Wednesday, the 15th of February, 2012.

Hi Simon

Hmmm, i see your point on the premise of your post.

Try this instead

http://www.cheapaccounting.co.uk/taxcompform.php

Posted by Shawn on Friday, the 28th of September, 2012.

As an independant corporation myself you're missing a huge factor.

This only holds true if you're making relatively small amounts of money,. If your income is high, it becomes VASTLY more efficient to use a corp,

For example, lets say Annual income is $300,000

As an individial, I would need to pay income tax on that, at 45%, so $135,000 goes to the Gvnmt.

As a corporation, I pay only 15% on that, or 45,000.

I can then pay myself up to $40,000 / year in dividends without paying any additional income tax, and beyond that the taxes go up.

Additionally, I can pay my Wife an additional 40,000 free of income tax.

So, there's many ways to skin that onion and it's not so cut and try.

Posted by Simon Harris on Saturday, the 29th of September, 2012.

Thanks, Shawn. I don't claim to know what the deal is in Canada, so your input is welcome.

Posted by Joseph Wang on Wednesday, the 21st of November, 2012.

It may be that you have an accountant has read too many accounting books from the US.

There are huge, huge tax benefits to forming a corporation in the United States. You can file a form and have your US corporation taxed as an S-corporation which means that profits are "passed through" without federal corporate tax.

In addition, you can almost anything as a business expense, as long as you can justify this as a business expense, you can deduct 100% of the cost. Personal deductions by contrast.

Finally, by limiting the amount you pay yourself, you can reduce payroll tax. The way that this works it that suppose someone pays you $90K. All of that is subject to social security tax. Now they pay you $90K to the corporation, and you issue $60K in payroll, only $60K is subject to social security tax. If you pay yourself nothing, then the IRS is going to get annoyed, but the rule is that as long as you pay yourself a "reasonable salary" it's fine.

The hiring company would also prefer to pay corp-to-corp. They can avoid paying employee contributions and fringe benefits.

Posted by A Zaidi on Friday, the 8th of February, 2013.

Posted by Suzanne on Saturday, the 23rd of February, 2013.

I am finding this very interesting. I am currently PAYE and being made redundant in a few months. Due to the job market in my field I suspect I need to go the consultancy route with significant PI. As far as I can tell I would not be accepted as a sole trader so will need to go the limited co or umbrella company route. I expect to earn approx 70,000pa. Any thoughts on what might be best?

Posted by Dan on Friday, the 12th of April, 2013.

Posted by Hari on Friday, the 19th of April, 2013.

Posted by Simon Harris on Monday, the 22nd of April, 2013.

Posted by Stuart on Sunday, the 12th of May, 2013.

Well done Hari, I agree, what a lot of twaddle. I've been contracting for 5 years now and my figures look a lot like yours, not to mention my shiny new laptop, Ipad, iPhone which I haven't paid any tax on! Then there's getting paid 0.45 per mile to commute to work. All stacks up for me

Posted by Simon Harris on Monday, the 13th of May, 2013.

Stuart -

You don't need your own company to make your work expenses tax deductible, that's basically my point. Not that those sound like genuine work expenses...

--

OK, so to prevent the noise drowning out the useful debate, from now on I'm not going to publish comments from people who haven't read the post, who resort to exasperated childish insults, or whose comments don't bring anything new to the conversation.

I also won't publish any more comments from people claiming that forming a limited company is a great way to dodge National Insurance payments. I've covered that in the article, and both the moral and mathematical aspects of that are something you can make your own mind up about.

Posted by Matt on Monday, the 27th of May, 2013.

Hi Simon,

I am currently contracting through an umbrella company. So to sum up would you advise continuing as I am or set up a limited company? BTW I am earning around 40k a year.

Posted by nigel on Monday, the 10th of June, 2013.

hi, not straying from this but i been self employed for last few years, subcontracted to deliver parcels and get a set wage every week, i pay for van hire and fuel, now company says i got to be voluntry vat registered and next month hire a new off the forecourt van, breakdown is 600 a week 88 van hire 200 fuel, now i get confused with vat registered as although i pay vat when hiring van or putting fuel in, i get a set sum every week but not with added vat, as the way most forums says to claim back you got to put in, is this worth doing??

Posted by Paul Muir on Wednesday, the 12th of June, 2013.

Posted by James on Saturday, the 29th of June, 2013.

Posted by Simon Harris on Sunday, the 30th of June, 2013.

James -

Hi, and welcome. Contracting is great, and I wish you the best of luck with it, but as I keep saying, you do not need to set up a limited company in order to claim your travel costs as tax deductible.

If these are genuine expenses incurred as a contractor, then a person who is sole trader/self-employed can claim them as tax deductible through their Personal Tax Return. No company needed.

Posted by Ben on Thursday, the 1st of August, 2013.

Posted by Rob on Sunday, the 11th of August, 2013.

Simon-- thanks for playing "devil's advocate". As a sole trader about to move to a Ltd Company you have at least given me some more food for thought. I have had years of run-around from bad accountants and appreciate it. More please.

Posted by Simon Harris on Monday, the 16th of September, 2013.

Norman - I couldn't agree more. Thanks!

Posted by Paul on Thursday, the 27th of March, 2014.

Hi, I'm starting a contractor job with Barclays next week, they have told me I need to register as a limited company or use an umbrella company?.... I've been registered as self-employed/sole-trader for a number of years already, doing my own tax returns online etc... I can't see why I would need to change from this?...surely I can just invoice them for my work as sole-trader status?... I don't want to pay accountants etc fees for something I can do myself.

Kind regards
Paul

Posted by Pete Davison on Monday, the 18th of August, 2014.

Simon,
Great post and series of discussion. I agree, it's disappointing to see 'personally disparaging' comments on a post that is simply trying to share knowledge around the contracting community.

I'm about to be made redundant and am planning to go contracting, so this has been one of my most useful finds to-date in terms of discussions.

Thanks for taking the time to share your knowledge and kick off the debate!

Cheers,
Pete

Posted by Isabel on Wednesday, the 21st of January, 2015.

Hi - thanks a lot for taking the time to write this.

I've been a freelancer/contractor for 7 years, happily as a sole trader, and am now being forced into using an umbrella company - one of the biggest legal rip offs in Britain. Now I'm certain Limited isn't a way out, it's just a lot more fuss.

I'd advise anyone to keep working as a sole trader and press clients to allow you to be. It saves you a lot of money, admin and fuss.

Posted by Dean Fergusson on Saturday, the 24th of January, 2015.

Posted by Anon on Tuesday, the 27th of January, 2015.

I can see nothing's been posted here for ages so I doubt I'll get a response, but you seem to really know your stuff so I figure that it's worth a try!

My boss is offering me the option to become a contractor, rather than a PAYE employee. He is encouraging me to get an accountant and set up a limited company for myself, so that I can take home more money. Thing is I am not on a huge salary anyway (less than 30kpa) so I am doubtful that I would really save any money at all. Could you offer me any advice on how I will be better off? Thank you.

Posted by Nigel Tilley on Thursday, the 21st of May, 2015.

After first year as limited company accountant bolted me right up and told me im running at near broke after putting so much of evenings spare time into it, really not worth it at all as an electrician on my own, even doing the accounts yourself, do you really want to give up all of your spare time for very little reward.

Posted by Massimo Amici on Sunday, the 31st of July, 2016.

Hi Simon, thanks. It's now 2016 and I've recently set up my Ltd company after working as a sole trader for 4 years, and not having needed an accountant, etc...

My mind has been scrambling to determine how this is all going to work and put more money in my pocket, and I've had the ongoing suspicion that it's not really going to help.

After these few years, have you developed further thoughts on the subject? Have you therefore closed your Ltd?

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