Operating as a sole trader is a relatively simple approach when it comes to managing your business taxes. Compared with trading as a limited company, your tax responsibilities will normally remain quite straightforward.
However, when your earnings increase, you may quickly realise that the tax costs of operating as a self-employed sole trader may outweigh its simplified benefits.
In this guide, we’ll explain how your tax liabilities and take-home pay can change as a higher earner self-employed and why it may be essential at this stage to consider incorporating your business as a limited company.
Why could tax efficiency decrease while your business earnings increase?
The short answer relates to the limited flexibility a sole trading business may offer when it comes to structuring your salary.
Simply put, self-employed taxable income will typically be charged at a 20% minimum rate Income Tax along with any additional National Insurance payments.
In real terms, this translates into £1,800 increase in Income Tax with £923 increase in National Insurance payments, when your annual earnings increase from £30,000 to £40,000.
Below is a simplified calculation of how the increase in sole trading earnings may affect your tax bill and take-home pay.
|Annual earnings before tax: £30K|
|Total take-home pay after tax||£22,195.40|
|Annual earnings before tax: £40K|
|Total take-home pay after tax||£ 28,472.90|
What makes limited companies a better solution for growing businesses?
Well, in most cases a limited company will provide its shareholders with greater flexibility when it comes to structuring their take-home pay.
As a company director, you’d be able to set a smaller portion of your income as Directors’ Salary, thus significantly reducing your Income Tax liability.
Furthermore, a director’s income could be paid as dividends and get taxed at a much lower Dividend Tax rate of 8.75%.
Below are some calculated examples illustrating the increased gap in take-home pay as your business grows in revenue.
With a £30K annual income, you should be £612.87 better off as a limited company shareholder and may see £1,362.12 net gain when your annual income reaches £50K.
|Annual Income||Sole Trader||Limited Company||Annual Benefit|
Other specific tax benefits for limited companies
Claiming back pre-trading expenses
Once your company has sufficient funds, you could reclaim expenses incurred during the period you were operating as a sole trader and up to 7 years prior to your company being incorporated.
Flat Rate VAT & Limited Cost Traders
IT contractors, consultants or freelancers are usually classed as low expenditure businesses and Limited Cost Traders, with a limited ability to reclaim VAT.
In this case, Flat Rate VAT becomes an attractive solution, as it allows Limited Cost Businesses to pay HMRC a lower tax rate from the 20% VAT they invoice their clients with.
Therefore, you could earn a little extra just by being registered for VAT.
Your personal circumstances may vary from the guidance provided in this guide, but as your business grows in revenue you should normally expect a rise in tax liabilities as well. It doesn’t mean you have to ‘foot the bill’, though. Advise with your accountant and assess your current tax position. You could quickly realise that incorporating your business may well be the next best step forward.
Lastly, please don’t hesitate to get in touch with your dedicated accountant at Clever Accounts, before making significant financial adjustments to your business.