Morag Watson: The self-employment conundrum

The summer Budget contained many surprises, some of which are only now beginning to take effect, and some that will not come into force for a while yet.

Morag Watson, partner and tax specialist at Scott-Moncrieff

The Chancellor made several changes that now beg a very important question – is it any longer worth turning yourself into a limited company by the process of incorporation?

Deciding on incorporation is one of the biggest issues that someone starting out in business will face, and becoming a sole trader or entering into a partnership is often the chosen route, but for others it might make perfect sense to begin life as a limited company.

The incorporation bandwagon really took off after 1 April 2000, when the first £10,000 of company profits attracted tax at only 10 per cent, and later even that rate was reduced to zero.

That all changed from 1 April 2006, when the zero rate was abolished. Suddenly a lot of people found themselves left with a company which no longer served its purpose. They had fallen into the classic trap of incorporating for tax reasons, rather than looking at what made the most commercial sense all round.

In recent years, incorporation had begun to look attractive again because it brought various tax benefits. These included entrepreneurs’ relief when a sole trader or partnership chose to incorporate, allowing the sale of the goodwill from their business to the new limited company – where appropriate conditions were met, the rate of capital gains tax was only 10 per cent. In addition, the sum due by the company to the proprietor for the sale of the goodwill could be left on the director’s loan account and be repaid without any further tax consequences over a period of time.

Then there were the cases of individuals who were sole directors and shareholders and who paid themselves a small salary but took the rest of their pay in dividends. In many cases, the individual did not necessarily need to extract money from the company, and so it could build up within the company at a much lower rate of corporation tax. At a later stage, there were ways in which this money could be extracted extremely tax efficiently, most usually through a members’ voluntary liquidation of the company. This would be treated as a capital gain, and entrepreneurs’ relief and a 10 per cent tax rate would be available, again as long as certain conditions were met.

It was no wonder that so many people plumped for incorporation at a time when a sole trader, for example, might well be subject to tax on their profits of 42 per cent or even 47 per cent including class 4 national insurance payments.

Now we have a very much changed tax landscape and tax advisers are having to think very carefully about incorporation on behalf of their clients. Last December, entrepreneurs’ relief on the disposal of goodwill on incorporation was abolished, as was the corporation tax relief which had been available to the company on writing off the goodwill – a double blow to individuals considering incorporation.

The summer Budget contained another “double whammy”, the first being the removal of the allowance for employer’s class 1 national insurance contributions – going up to £3,000 next April – from those companies where the director is the sole employee. The second blow will be the scrapping from next April of the 10 per cent tax credit on dividends. Every individual will have a £5,000 dividend allowance, and any dividends received over and above this will be taxed at 7.5 per cent for a basic rate taxpayer, 32.5 per cent for a higher rate taxpayer and 38.1 per cent for an additional rate taxpayer – taking a small salary and topping up with dividends is suddenly looking much more expensive, particularly where those dividends are in excess of £5,000.

It would appear that we have reached a point where the tax advantages of an incorporation are being steadily eroded, but as long as we have relatively high rates of personal taxation and national insurance applying to sole traders and partners, then the prospect of sheltering money within a company should still be considered.

It may be less advantageous than before, but there may still be very good reasons, both tax and non-tax, for making such a choice.

• Morag Watson is a partner and tax specialist at accountant and business adviser Scott-Moncrieff