One of the most common questions we at The Peloton are asked is, “should I incorporate my business?” Read any article or blog post and the answer is, invariably, “it depends.” While true, that isn’t very helpful! What we plan to do instead is outline an approach you can use to begin answer that question yourself.
We suggest approaching the question in four stages:
- Outcome: What are you trying to achieve?
- Net Pay: What is the impact on net pay?
- Other Benefits: Are there other factors that make this worthwhile?
- Downsides: Are there any drawbacks?
Step 1. Outcome: What are you trying to achieve?
Not merely for your business but for your personal life too. Are you planning to get married, start a family, retire early, move abroad, change career, etc.? We can so easily fixate on deciding whether incorporating makes sense, right now, this year. It’s much more important though to take a broader view and assess whether incorporating is the right answer long term. As well as these personal questions it’s important to have a really clear picture of where you want your business to go:
- How much profit are you planning to make this year?
- What about next year and the year after?
- How quickly are you expecting your business to grow?
- How much money do you need to withdraw each year to cover your living expenses?
- How much money would you like to withdraw each year assuming you hit your targets?
- Are you planning to reinvest some or all of the profits in the business and, if so, how much?
- Will you need to draw more profit from the business in future, e.g. when children start university?
- What is your ultimate exit strategy, e.g. winding down the business, selling to staff, IPO, passing on to children, etc.?
- When would you be looking to step back, sell, etc.?
We suggest taking a thorough review of all aspects of your life and business. Really take the time to plan out what you’re aiming for long term. We need to decide whether incorporating fits into that plan.
Step 2. Quantify: What is the impact on net pay?
Time to run the numbers!
The first thing to do is to work out your net pay currently. Sole traders and partners pay income tax on their profit, as well as Class 2 & Class 4 National Insurance. After crunching the sums, the result might look something like this:
The second step is to compare this with the corporate position.
There are a few points to make here:
Salary: many company owners choose to pay themselves a small salary. Provided the salary is covered by the tax-free personal allowance (£12,570 in 2021/22), no income tax is due and so long as the salary is under the primary threshold for national insurance (£9,568 for 2021/22), no Class 1 Primary NIC is due either. By paying this tax free, NIC free, salary one reduces the corporate tax bill which makes it more efficient than drawing dividends.
Employer NIC: employers owe NIC at 13.8% on salaries above the, “Secondary Threshold.” This Secondary Threshold is slightly lower than the point at which employees owe NIC and so a small amount of Employer NIC may be payable by the company on a company owner’s salary.
Dividend Allowance: the first £2,000 of dividends one receives in a tax year are completely tax free. This is on top of the tax-free personal allowance. The £2,000 still uses up one’s basic rate band though so can be thought of as a kind of zero rate band.
Dividend Rates: appear lower than rates for non-savings income (e.g. salaries) namely, 7.5% vs. 20%, 32.5% vs. 40% and 38.1% vs. 45%. It’s important to remember though that dividends are paid net of corporation tax whereas salaries are paid pre-corporation tax. So in reality the rate for dividends (ignoring personal and dividend allowances) once one factors in the corporation tax is in fact slightly higher, 25.075% for basic rate, 45.325% at higher rate and 49.861% at additional rate. On the other hand, National Insurance is not due on dividends which can be a big saving particularly on income up to £50,000.
We can see from this indicative example that an individual making profits of £125,140 could realise significant savings by incorporating (just under £5.5k), even if they withdrew everything each year. Were they to reinvest profits, make significant pension contributions, etc. the savings could be even greater. Looking forward five years, potential savings in the region of £27,500 would be an amazing result!
Step 3: Other Benefits: Are there other factors that make this worthwhile?
Say you carry out the net-net calculations and there is a small benefit, say £1,000 a year. Given the increased admin and fees involved with running a company one may conclude it’s not worth doing just yet. That’s a fair position to take but before ruling it out completely it’s worth mentioning that securing a pure net pay advantage is rarely where the true value of incorporating lies. Some additional things to think about include:
Reinvesting: A business may be looking to reinvest profits in other ventures. For example, a buy-to-let business might be saving up to purchase another property, adding to its portfolio. As a sole trader, potentially paying tax at 45%, one has just 55% of profits available to put towards this new property. By contrast, retaining money within a company, means one keeps 81% of the profits. This would allow the company owner to purchase much more quickly than a sole trader, allowing the business to accelerate its growth and increase profits over a shorter timeframe.
Income Splitting: There is scope to gift your non-working spouse shares in the business to utilise another personal allowance, dividend allowance and basic rate band. These allowances and rate bands alone have the potential to save £13,154 in tax each year for an additional rate paying sole trader.
Income Smoothing: Unlike sole traders, who pay tax whenever income is earned, owners of companies can time when they extract dividends. By smoothing income across years, or spiking income up and down strategically, they can realise gains. One might want to smooth income to avoid tipping into higher rate bands. For example, the effective rate of tax between £100,000 and £125,140 is 60% due to the personal allowance phase out. If one’s income is hovering at between £95,000 and £110,000 each year, trying to smooth this to stay at £100,000 could be sensible planning.
Spiking: Individuals earning over £50,000 begin to lose their entitlement to child benefit. For larger families this can be a significant amount of money to lose. Similarly, tax free childcare can be lost where parents earn over £100,000. Say one wanted to retain child benefit payments but one is earning around £70,000 a year. One approach might be to pay £50,000 of dividends one year and £90,000 the next. Over a two year period the same amount is paid but, by spiking income, the individual is entitled to child benefit every other year whereas the sole trader would receive nothing.
Capital Gains: In certain instance it is possible to extract value in a company at GGT rates, as opposed to income tax rates. That one might be able to pay tax at just 10%, rather than 45% or 38.1% is definitely an attractive prospect. In some more niche scenarios, such as eventually selling one’s company to an Employee Ownership Trust (EOT), it can even be possible to pay no tax whatsoever! If the plan is to grow a company then sell it, this is definitely worth considering.
Annual Allowances: If one is imminently planning to sell the business, incorporation can in certain circumstances offer CGT planning potential. By, “selling” your business to the company one year, then selling your shares in the company to a buyer the next, one can benefit from two annual allowances. In a three person partnership, that could be a £7,380 tax saving.
Shares: The creation of shares opens up a new avenues for raising capital. You can now attract investment in your business, potentially in very tax efficient ways such as by using the EIS and SEIS schemes. Such investment can be crucial in taking your business to the next level. One can also remunerate staff more tax efficiently via share schemes, making it easier to recruit and retain talented professionals.
Planning Points: There are a whole host of planning options which open up once one has two legal entities, the owner and a company. To name just one, a sole trader cannot rent out his home office to the business since one cannot rent something to yourself. By contrast, this is a perfectly legitimate thing for a company owner to do, thereby reducing the tax bill. Care must be taken here though as there can be an impact to Private Residence Relief on the eventual sale of the home without careful planning.
Inheritance Tax: Corporations, with their share structure, can allow for more flexibility when it comes to inheritance tax planning. Where one is planning to hand your company on, particularly to more than one person, exploring the advantages of incorporation is a sensible thing to do.
Step 4. Downsides: Are there any drawbacks?
With such a long list above one might be tempted to conclude, “sign me up!” However, it’s worth pointing out that incorporation won’t make sense for everyone. Incorporating comes with additional compliance obligations and costs which need weighed against any benefit. For low earners and very high earners, the net-net calculations can even show a saving to being a sole trader. It’s always important to carry out the necessary calculations and checks for your specific circumstances.
Even if incorporating does make sense, there is the question of timing. Ensuring that incorporation is timed correctly is crucial to prevent losses arising for which no tax relief is available. Similarly, the annual investment allowance (AIA) and first year allowances (FYA) are not available in the final accounting period. As such, where businesses have made significant capital expenditure it can make sense to delay incorporating to ensure these allowances can be fully utilised.
So should you incorporate? Well, once you’ve answered all the preliminary questions above you’ll be in a great position to answer!
Of course this article is not comprehensive; whole books have been written on this topic. Hopefully though you now have a better idea of the potential benefits of incorporation as well as the range of issues you need to consider. If you would like to discuss your specific circumstances in more detail please do not hesitate to let us know. We would love to help you work through, what can be, a key milestones for you and your business.