Incorporation – The Forgotten Tax Planning Tool

During the mid to late 2000s, when the top rate of income tax was as high as 50%, operating as a limited company was viewed as the ‘gold standard’ in terms of tax-efficiency and shareholder protection. In the 10 years or so that have passed, there has been a gradual move away from this with more and more individuals, whether that be sole traders or partners in a partnership, deciding to operate as self-employed.

However, with the current tax regime squeezing middle to high earners, together with the introduction of higher rates of Scottish Income Tax, now is the time to start considering whether a business incorporation would again be beneficial.

A comparison of the tax rates at play are stark; Profits within a limited company are subject to corporation tax at 19% (falling to 17% from April 2020), compared to self-employed profits which can be charged to income tax at rates as high as 46% (for Scottish taxpayers). Additionally, self-employed individuals are subject to Class 2 & 4 National Insurance Contributions, which add an additional tax burden.

In basic terms, incorporation could reduce the tax payable on business profits. However, personal taxes due when company profits are extracted must also be considered.

The transfer of any business assets to the limited company, such as goodwill or land and buildings, will be treated as chargeable disposals for Capital Gains Tax purposes. These disposals must take place at market value and any gains will be charged to tax at the reduced rate of 10% (excluding goodwill which is taxed at 20%).

The disposal of any business assets to the company will create a ‘loan account’ of funds due to the Directors’ (equal to the market value of the assets) and this can be withdrawn tax-free in a similar way to drawings from a sole trade or partnership.

Additionally, the creation of the loan account allows shareholders to structure their personal tax affairs in such a way that the majority of their required annual income is taken tax-free, with ‘top-up’ salary and dividends to utilise allowances from HMRC that would otherwise be wasted.

There are numerous other benefits to business incorporations, such as:

• For additional rate taxpayers, their individual taxable income will be reduced to a level which will retain the full £40,000 allowance for pension purposes
• Employer pension contributions could be made directly by the company to obtain corporation tax relief and utilise the above pension allowances
• Limited liability can be achieved to reduce the individual’s legal responsibility for the debts of the business

An incorporation may not be suitable for all businesses, but if this is something that you think may be a benefit you, we can prepare an Incorporation Review. Please do not hesitate to contact the Private Client Tax Team, or your usual AAB contact.