Perhaps you set up a limited company to house your small business because somebody told you it was more tax effective? A lot of people running very small businesses do so through a limited company now, instead of as a sole trader. It means more admin, more expense, but it does give you more options when you look at how you pay yourself, and therefore how much tax you pay.  So how can company director pay work?

CoinsAs a sole trader, you are taxed on every penny of profit, whether or not you withdraw it from the business. You have to pay self employed National Insurance Contributions, and you have to pay income tax.

As a limited company, the company is taxed on every penny of profit, but most likely at the small company corporation tax rate of 20%. Profit is taken after all tax deductible expenses, including salaries, which means that your salary is a tax deductible expense to the company. You are then taxed on any income you take from the company, whether salary or dividends.

So what is it that makes it so tax efficient to set up a limited company, instead of operating as a sole trader?

(UPDATE:  The below now only applies to the 2015-2016 tax year and earlier.  Taxation of dividends is now changing further to the last budget – watch this space for more information).

Let me give you an example (updated for 2015-2016 tax rates and thresholds). Your business makes profits of £30,000 before you take any money from it. As a sole trader (and assuming this is your only income) you would pay tax as follows:

Personal allowance £10,600 – nil
Basic rate above £10,600 @ 20% – £3,880
Class 2 NICs @ £2.80 a week – £145.60
Class 4 NICs @ 9% above £8,060 – £1,974.60

Total self employed tax – £6,000.20

As a limited company, assuming you are paying yourself a salary of £883 a month (see more below) and all of the remaining profit as a dividend, you would pay tax as follows:

Company profits before salary £30,000
Company profits after salary £19,404
Corporation tax @ 20% – £3,880.80
Profit after tax – £15,523.20

Dividend – £17,248 (this is the profit after tax x 10/9 to take account of the dividend tax credit)

Personal allowance £10,600 – nil
Basic rate above £10,600 @ 10% for dividends – £1,724.40
Less (capped) dividend tax credit £(1,724.40)

Total income tax – nil

Employee’s Class 1 NIC – £303.84

Its a bit complicated when you start factoring in dividend tax credits, but essentially if you are a basic rate tax payer you pay no further tax on any dividend income. Your overall tax burden as a limited company is therefore only £4,184.64 – a huge saving of £1,815.56 compared to the sole trader tax position.

Why pay yourself a salary of £883 a month from the company? This salary uses up your tax free personal allowance, and while the £2,000 employment allowance is still available for owner managed businesses, no employers NICs are payable (assuming there are no other employees).

There are many other things you ought to think about if you are considering incorporating your business, including directors responsibilities, your overall remuneration strategy including paying into a pension, the increased admin and expense of running a limited company to name just three. But the headline tax savings have got to be worth thinking about if your business profits go much over the personal allowance.

(UPDATE:  The above now only applies to the 2015-2016 tax year and earlier.  Taxation of dividends is now changing further to the last budget – watch this space for more information).