Contractors: Setting Up a Limited Company is not "Tax Efficient"
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.
Simon Harris
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.
Paul Green
so you know where I'm coming from I'm an accountant.
I think you have rather glossed over the effect of National Insurenace. Class4 NIC would be payable on the profit in the business above the lower earning threshold of £7,225. In your first example of £40,000 profit that would be £2,949.75 ((£40,000 -£7,225)*9%) Not to be sniffed at.
The bigger worry of operating through a limited company is the treat of IR35 regulations
Also i would suggest you would need to take out PI insurance however you are set up.
Paul
Ida Rolek
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).
Ida Rolek
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
Ciaran McNulty
@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.
Simon Harris
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...
> 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.
> 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.
Ian
You might take a look at
http://www.uktaxcalculators.co.uk/dividend-vs-salary.php
for a quick and easy calculator/comparison
Simon Harris
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?)
just me
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.
Simon Harris
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.
Ian
Hi Simon
Hmmm, i see your point on the premise of your post.
Try this instead
http://www.cheapaccounting.co.uk/taxcompform.php
Shawn
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.
Simon Harris
Thanks, Shawn. I don't claim to know what the deal is in Canada, so your input is welcome.
Joseph Wang
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.
A Zaidi
I am about to start a franchise up (driving instructor) where I will be paying a weekly franchise fee. Will it not be better for me to work through a limited company to be able to deduct the franchise fee before tax? If I have to pay the franchise fee after my tax then I will be circa £5k a year worse off. Also there would be deductions for car cleaning (car has to be kept very clean) and also fuel comes out of my pocket so I suspect I can claim vat back back on that if I am vat registered, correct?
Suzanne
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?
Dan
An interesting post indeed Simon. Having been contracting via a limited company for a year now, I've reached the same conclusion; that there are few financial benefits of limited vs sole trader, but there is a whole raft of extra complexity and paperwork.
The VAT FRS isn't all it appears to be - it doesn't take long before expenses eat up the margin allowed.
Company car tax is rocketing, so even that is barely financially viable.
That said, my options were to go limited or use an umbrella company - and there is definitely a saving to be had with the former. Using an umbrella meant about £1500 in fees plus employers NI at 13.8% on earnings above about £7500.
Hari
This article is well meaning rubbish!
The savings made through a Ltd Co are huge for the average contractor.
Assuming £300 a day and a 46 week work year.
Ltd Co.
Salary £7,488
Flat Rate VAT Savings £2,622
PAYE £0
Employer's NIC £0
Corporation tax £12,512
Dividends £50,046
Tax on Dividends £4,640
Monthly Take Home £4,425
Same scenario in employment via umbrella, PAYE
Salary £59,776
PAYE £13,794
Flat Rate VAT Savings £0
Employer's NIC £4,530
Corporation tax £0
Dividends £0
Tax on Dividends £0
Monthly Take Home £3,472
Thats a grand a month difference and the calculation includes accountancy fees.
Sorry, but this blog is seriously deluded and has not even a tenuous connection with reality.
Simon Harris
Thanks, everyone.
Hari - once again I have to point out that I'm not comparing PAYE versus limited company here.
Incidentally, a quick glance suggests your PAYE numbers to be incorrect. (300 * 5 * 46) is £69k.
Stuart
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
Simon Harris
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.
Matt
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.
nigel
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??
Paul Muir
Thanks Simon,
I myself am about to leave full time employment and venture into contracting. The majority of searches I do inevitably end up at some accountancy firm, which although great as a lot of them do explain the ltd company procedure, they don't drop in the fact that you don't necessarily have to do the umbrella or ltd company thing.
I agree with your point about how could you possibly be better off by buying gadgets and gizmos, your still spending your cash...
So from what you have experienced so far running your own company, would you advise against setting one up, if for instance you were looking at a £360 (not $) contract over the course of two years, not just on a financial basis, but also admin & complexity of the process?
Your thoughts would be greatly appreciated.
Paul
James
I m considering ditching working for a firm and going contracting. The money is at times 4 times more eg £800 p/d for a 12m contract. i used to be put off by lack of security etc versus being employed... These days nothing is secure comparatively so why not make some lolly hey?
The reason I understood LLC was better over paye is because I could claim back all my costs ... I pay £5,500 a year for the privalige of using a train to and from work, suits, computers work space at home and so on... Surely it is a no brainer for me?!
Ben
Hi Simon,
Your maths has missed out one important factor that differentiates being a sole-trader against being a directory/employee of a Ltd Co.
As a sole trader, you are liable for Income tax, Class 2 NICs (the ~£2.50 per week direct debit) AND most importantly Class 4 NICs (~8%).
So under the higher rate tax bracket, you are looking at 20% Income tax PLUS 8% Class 4 NICs - effectively 28% tax.
Whereas as a Ltd Co. under the same earnings, you are only subject to Corp tax (~20%) - the dividends are taxed at 10% less a 10% tax credit, ie. 0% tax.
So your equivalent drawings between a Ltd Co. and a sole trader is almost 8% difference at the lower end of the scale, and more still at the higher end (with the various director credits and small business credits).
The difference between operating as a Sole Trader vs. Ltd Co. are vast and tax efficiency is absolutely a key driver to select operating under one.
Any accountant can easily demonstrate the differences - you've missed the fundamentals of income derived taxation and seemingly glossed over the sheer importance of NICs.
Rob
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.
Simon Harris
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.
Simon Harris
Norman - I couldn't agree more. Thanks!
Paul
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
Pete Davison
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
Isabel
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.
Dean Fergusson
Be aware of the VAT FRS. For example for IT it's 14.5%. You may think 'OK, I add 20% on but only have to pass on 14.5% leaving me 5.5% - wahey!'. But the 14.5% is charged on the invoice total not as a part of the added 20% so £1000 + 20% = £1200, 14.5% of this being £174 rather than maybe the £145 you might expect... or something like that...
Anon
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.
Nigel Tilley
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.
Massimo Amici
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?
Ciaran McNulty
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