Setting up a Ltd Company to save tax was historically seen as an easy way of saving tax and national insurance (NI). However, a succession of changes since 2016 has largely curbed the tax efficiency.
Reform of dividend taxation in 2016
It all began with the reform of dividend taxation in 2016. Before this, dividends were treated as being received net of a notional tax credit which was deductible in the self-assessment tax computation and meant any dividends that fell into the basic rate band did not actually suffer any tax so setting up a Ltd company to save tax was beneficial.
The 2016 changes scrapped this notional tax credit and the concept of a net dividend. Now, all dividends are received gross, and taxable at 8.75%, 33.75%, or 39.35%, to the extent that they fall into the basic, higher or additional rate bands. The stated aim of the overhaul was to combat ‘tax-motivated incorporation’ & discourage anyone from setting up a Ltd company to save tax.
2016 also saw the introduction of a dividend ‘allowance’, which is really a 0% band. The 2022/23 dividend allowance is £2,000 (originally £5,000), and the intention is to ensure investors with modest shareholdings were not impacted.
Should I consider setting up a Ltd Company to save tax?
When considering setting up a Ltd company to save tax, you need to factor in the 2023 corporation tax rate increase and it is unlikely to be worth doing so from a purely tax-motivated angle unless it is fairly certain that profits will remain within a fairly narrow band, around £50,000 to £75,000.
However, the tax efficiency could be increased in a number of ways depending on the circumstances. For example, the director shareholder may not require all the profit to be extracted every year. Profits left undrawn as dividends will still be subject to corporation tax of course, but will not be subject to income tax until they are withdrawn. If this takes place in a later year, perhaps when profits are lower, or post-retirement, they could be subject to a lower rate of dividend tax.
The undrawn profits could also be put to use for the company to make investments in its own name. This does not solve the tax efficiency issue but could increase the distributable profits going forward.
An alternative strategy would be to use the undrawn profits to make pension contributions as the employer. These would be deductible for corporation tax, but of course, the downside is that the money is then locked away until pensionable age is reached.
If these options are not suitable, i.e, because the director shareholder needs as much money as possible from the company each year, a powerful strategy would be to bring a spouse or civil partner in as a second director shareholder.
This would eliminate secondary class 1 NI contributions, as the employment allowance would then be available. It would also have a drastic effect on the corporation tax and income tax charged.
Firstly, assuming there is no other income, both directors would withdraw a salary, saving corporation tax of up to 25%. Secondly, the income paid out to the individuals would enjoy the benefits of two personal allowances, basic rate bands and dividend allowances.
In fact, returning to our company with profits of £100,000, assuming both directors take a salary of £12,570, the corporation tax bill falls by over £3,000.
Assuming the dividend is split equally, neither director shareholder breaches the higher rate threshold, and the income tax bill is less than £5,000. Overall, the change to a two-person company saves over £12,000, leaving our happy couple with £79,200.
To sum up, the days of the old ‘one-man (or woman) band’ setting up a Ltd company to save tax may be numbered, but there is certainly still a place for incorporation with tax savings in mind.
Setting up a Ltd company to save tax may be subject to future attacks by the government to tackle any tax-motivated incorporation.
How can I extract profits?
The surprise announcement of the Spring Statement in March 2022 was undoubtedly the decision to increase the NI payment thresholds, including the primary threshold to the level of the income tax personal allowance. However, this has been complicated by the fact that the primary threshold increase takes place from July rather than the start of the year.
The profit extraction strategy often revolves around what level to set the director’s salary at. In previous years, it has generally been optimal to restrict this to the level of the secondary threshold, unless the employment allowance is available (where a salary equal to the personal allowance is slightly better).
For 2022/23, the optimum salary for a director with no other income outside the salary and dividends will be £11,908 following the change to the primary threshold. If the employment allowance is available, it will be very slightly more efficient to increase this to £12,570, but in practice the difference is minimal.
How can MCL Accountants help?
Contact MCL Accountants on 01702 593 029 if you have any queries on Setting up a Ltd Company to save tax or if you need any assistance with the preparation and submission of your business accounts or self-assessment tax returns to HMRC.
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Ishan provides financial management, taxation and transactional advice to business entities of all sizes. His expert areas include statutory compliance, business taxation, personal tax & transactional processing and systems. Industry sectors include professional services, retail, hospitality and entertaining & media and advertising services.