There has historically been a point where having a limited company became more tax efficient than being a sole trader. This is due partly to the use of dividends and partly to the differences in how National Insurance is charged between the two models. These two factors are changing, and changing in ways that will make becoming a limited company far less attractive to many small business owners.
Dividends are a widely understood as the most tax efficient way to remove money from a limited company however as of April 16 this all changes. Dividends will be taxed above £5,000, at 7.5%, 32.5% and 38.1% depending on whether you are in the basic, higher or additional tax brackets. Whilst dividends were taxed previously, a tax credit worth the same as the tax cancelled it out. Now at basic rate tax any dividends over £5,000 will be taxed so if you draw a £10,000 dividend this will result in a £375 tax bill, not huge, but it mounts up.
Limited companies are currently able to access the Employment Allowance, this allowance, worth £2000 covers employers National Insurance up to £2000 for all employees, including single Director, one employee limited companies. As of April 2016 single employee, Director owned business will not be eligible. Companies will only be eligible if they employ more than one employee. Effectively this rules out most small limited companies where many have only the Director as the employee. On a £10,000 annual salary this will increase the costs by around £270.
Now there is another side to this, sole traders currently pay two types of national insurance. Class 2, which is a weekly payment of £2.80 and class 4 paid along with tax based on profits from your tax return. As of April 2018 the weekly payments will be abolished saving sole traders around £150 a year.
Corporation tax, currently set at 20% will reduce to 19% April 2017 and 18% in April 2020 and the personal tax allowances are set to increase to £11,000 April 2016 and £11,200 in April 2017.
So whilst there are gains and losses to those running limited companies one thing is for sure, there are far more factors to consider than how much the tax saving will be. For some small businesses they need the protection offered by becoming a limited company, and for those whatever the additional costs, it has to be. For others considering the change make sure you take advice before taking the step, the answer to which is best for you may not be a as simple as it once was!