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:

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.

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 Simon Harris on Monday, the 11th of February, 2013.

Hi A -

I couldn't possibly advise on your particular situation. I think you'd really have to speak to other instructors and/or a specialist adviser.

Generally speaking, the things you mention such as tax deductible costs and VAT do not inherently require you to set up a company. That's a common misconception, but in fact self-employed people can be VAT-registered, and can claim back costs on their Personal Tax Return.

But still, your situation sounds quite specific, so your, er, mileage may vary.

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 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!

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