Tax
For this article we will focus only on the 2017/18 tax year.
Our tax comparisons assume a simple position where the only income being earned by a person is either their sole trader income or their salary and dividends from their limited company i.e. there is no other personal income to consider, such as rental income.
Sole Trader Tax
As a sole trader an individual must pay tax on all profits over and above their personal allowance, for most tax payers the personal allowance is £11,500 for the 2017/18 tax year.
Once the personal allowance has been reached tax is paid at the rate of 20% (basic rate of tax) up to £45,000 income, 40% as a higher rate taxpayer (over £45,000) and 45% in the additional rate band (over £150,000 income).
As well as tax, for a sole trader there will be two forms of national insurance to consider, Class 2 and Class 4.
Limited Company Tax
A limited company, on the other hand, pays corporation tax on profits at a rate of 19% from 1 April 2017 (previously 20%). Over and above this there can be personal income tax to be paid with regard to dividends taken from the business.
In order for the extractions to be as tax efficient as possible the director normally would draw a small salary from the company within their personal allowance but not above the point at which national insurance becomes payable; this salary would be an allowable business cost for corporation tax so 19% corporation tax is saved on the gross salary.
The remainder of their withdrawals would be in the form of dividends. These are paid out of post-tax profits and are not deductible expenses for corporation tax purposes so offer no tax saving. However there is no national insurance to pay on dividends.
In the 2017/18 tax year dividends are taxed at 7.5% in the basic rate of tax, with rates of 32.5% & 38.1% in higher and additional rates respectively.
The first £5,000 of dividends that would otherwise be taxable at the above rates are currently subject to a tax free allowance.
There is no requirement for the owner to withdraw all profits from the business if they do not want to, and indeed it can prove tax efficient to leave some profits retained in the company for extraction at a later date or to re-invest in the company.
In the table below we outline the tax savings of a limited company compared to a sole trader for different levels of profits based on the 17/18 tax year.
We have assumed an optimum level of salary and dividends in the scenario of a limited company and the figures include national insurance payable as a sole trader.
The profits are on a like-for-like basis so do not include the directors salary for the limited company.
Tax differences of a sole trader vs limited company for 17/18: