Incorporation

Incorporation has been a well trodden path for many years by business proprietors seeking to minimise their tax burden.

Since the 0% band of corporation tax back in the early 2000's encouraged a rush of new companies to be formed, successive Budgets have sought to narrow the disparity between the tax on trading through a company and trading as an unincorporated sole trader or partnership, to the point where the differences had become so marginal that the additional costs of running a company might not have been thought worthwhile. As a result we have seen a slowdown in businesses incorporating in recent years.

So with the recent changes in income tax and national insurance, in particular the 50% additional rate, should incorporation be back on the agenda?

The numerical comparisons below illustrate the tax differences between £100 profit earned by a company and then fully distributed by dividend against the same £100 profit earned by a sole trader at the basic tax rate, the higher tax rate and the additional tax rate.

Table 1
Using 2011/12 rates

As can be seen, it is only really at the basic rate band that there is any significant tax benefit from operating as a company, providing a £9 per £100 advantage, which over the basic rate band of £35,000 would amount to a £3,150 annual cash benefit (before considering additional costs of administration).  At the higher rate and additional rate bands, the cash incentive is relatively small.

However, the corporate option really comes into its own in situations where the business proprietor is earning profits in excess of personal requirements.  Where profits can be retained in the business that can then be used for capital investment or debt capital repayment, there is a significant difference in the outcomes.

Consider the position where a business earns annual profits of £300,000 but the proprietor only requires cash of £100,000 a year.  In an unincorporated business, income tax and National Insurance are still assessed on the proprietor on the whole £300,000, despite the fact that only £100,000 is required as drawings.  The tax and NI bill on the sole trader is a frightening £132,586 (44.2%!), leaving only £67k for reinvestment in the business, after the £100,000 drawings are taken (see table below) 

In the company, the profits of £300,000 (less a small salary just below the primary threshold for National Insurance of £7,000) are only taxed initially at 20%.  Dividend payments of £113,358 are then made, which after higher rate tax on the relevant amount will leave the shareholder/director with £100,000 cash (including the salary).  This leaves £121,042 in the company for reinvestment/debt repayment - £53,628 more than the unincorporated business.

Table 2
Assuming:

• £300k profits pre-tax
• Only £100k personal after-tax cash required
• Excess cash for reinvestment/debt repayment

Using 2011/12 rates

So for a growing business where profits need to be retained to fund investment in fixed assets and working capital or to pay down debt, the corporate option makes a lot of sense.

A further incentive is the value that may be achieved on incorporation by the proprietor for the sale of an established business’ goodwill. A database of private company deals comparing 2009 with 2010 has shown a 25% increase in PE ratios. This means that goodwill valuations for incorporation should be improving also. With the 10% capital gains tax rate for qualifying disposals, this provides further opportunity for the business owner to extract profits at a reduced tax rate.