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How do I pay tax if I run my own business?

Tax expert Mark Lee offers advice on how to deal with tax if you are running your own business

 

by Mark Lee on Jun 01, 2010 at 00:01

Tax expert Mark Lee offers advice and answers you questions on how to deal with tax if you are running your own business.

Do I need to form a company?

Many people assume that being in business means you run your own company. But that’s not necessarily so. There are actually four alternative common forms of business structure:

  • a sole trader;
  • a conventional partnership (where you work with one or more partners in the business)
  • a limited liability partnership - LLP - (this provides you and your partners with the protection of limited liability, just as with a company); or
  • a limited company.

You can choose which best suits your needs from a commercial and tax perspective.

In recent years there has been a tendency to incorporate businesses as limited companies solely because the tax system seemed to enable small companies to pay less tax than sole traders and partnerships. In practice there are also a host of commercial and practical issues to consider when choosing between the four principal alternative business structures.

In practice it’s rarely a good idea to just leap on the 'incorporation' bandwagon without clarifying whether or not this will be right in your specific circumstances – and even more so now that the hoped for tax advantages are less certain.

Can losses be good for me?

It’s a rotten thought but plenty of new businesses take some time to make a profit. One of the benefits of starting your business as a sole trader or partnership is that it’s easier to get tax relief for any losses that you make. On the contrary, if you start your business as a company your options are limited. The only relief for losses will be to carry these forward and offset them against future profits in the company. This is a much less attractive option.

How are my profits taxed?

Many people make the mistake of choosing to start their business as a limited company without considering all of the related issues. Some do this because they assume that all businesses are companies. Others do it because they have heard that companies pay a lower rate of tax on profits than the income tax payable by individuals.

While that’s true, it’s like comparing apples and oranges. Yes, companies pay only 21% tax on their profits but you are also subject to income tax on the monies that get paid to you by the company.  The comparison of tax rates will depend on a number of factors and, contrary to popular belief it is not possible to make a quick comparison of the overall tax burdens. Indeed, it can be a mistake to try to choose which business structure is best for you solely by reference to simplistic comparisons of headline tax savings. These will invariably be misleading.

It can be dangerous to assume that incorporation will be preferable in the longer term just by reference to an apparent headline tax saving in the current year.

If I do form a company, what factors should I consider?

In practice the real difference in comparable tax burdens year on year will depend upon a range of issues, including:

  • the relative level of salary and dividends to be paid by the company and any restriction on the potential timing or level of dividends;
  • the timing of dividend payments and the impact of these on annual income as regards entitlement to tax credits;
  • the level of non-deductible business related expenditure such as entertaining;
  • business use vs. personal use of car or van and whether this is to be owned personally or by the company;
  • timing of incorporation and the funding of self assessment tax payments re the final period of pre-incorporation trading;
  • the extent to which profits will be retained in the company to fund capital expenditure and expansion;
  • the extent to which any surplus profits will be retained or used to fund capital items
  • whether goodwill is to be 'sold' to the company and the sale proceeds funded out of post  corporation tax profits; and
  • the extent to which post-corporation tax profits will be used to fund loan repayments rather than dividends.  

How are my profits assessed for corporation tax?

It's also important to be aware that companies pay corporation tax on their profits. The taxable profits of a company are identified after deducting all salary payments including those paid or payable to the owner.

Dividends however are not deducted. Company law requires that dividends are paid out of a company's reserves which means what's left after the corporation tax has been charged on the profits. Salaries are subject to tax and National Insurance at up to 51%. Dividends are only subject to income tax if the shareholders taxable income makes them liable to higher rate tax. In such cases 25% tax is payable on the amount of dividend received by the shareholder.

This guide is general in nature and not intended as advice so please check your own circumstances. The guide has been provided by Mark Lee of the Tax Advice Network which is the UK’s largest network of vetted, independent, specialist tax advisers.

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