Limited companies have always been a very tax efficient vehicle for companies and their Directors, but various changes in other taxes and allowances mean this may not continue to be the case.
The first signal that the Government may be willing to restrict the tax efficiencies open to limited company directors, came with the introduction of the dividend tax back in 2016. For those drawing their income as a blend of salary and dividend, this introduced a form of extended income tax over the portion not covered by the PAYE system. Although the dividend tax was set at a lower rate and provided an initial tax free allowance, it still created the levers for future taxation.
So, what’s changed to mean that limited companies may no longer be as personally tax efficient?
Dividend Tax Increases
Whilst the dividend tax rate has not been changed since its introduction, the tax free allowance has been reduced and now sits at just £2,000, creating an effective increase in the rate of taxation. The allowance at this level is deemed not to penalise small time investors, but it creates an alternative narrative for those using dividends as a means of drawing income from their company.
Personal Allowance Increases
For almost a decade, the personal allowance has increased nearly every year, up to its current level of £12,570 today. This is the amount of money somebody can earn before paying tax at the basic rate. The basic rate of 20% is then payable on the income between £12,571 and £50,270, after which point the higher rate tax of 40% is applicable.
Whilst the increase in the personal allowance has only provided a few (£) thousand of further tax free income, it does encourage people to draw more of their income through the PAYE system. For some, the combination of more tax free income through PAYE, less tax free dividends, and the knowledge that their personal tax is taken care of at the point of earning, has led them to move to a 100% salary, from the traditional part salary, part dividend structure. This is further compounded by changes in company taxation rates.
Successive governments have signalled that they intend to make the UK a low tax economy, so as to encourage businesses to relocate and stay here. But the Covid pandemic and need to repay billions in government borrowing has led to the Johnson government, to cancel planned reductions in the corporation tax rate. Previous suggestions had been made that this could be reduced as low as 15%, but a further reduction to 18%, planned for April 2022, was wiped out leaving the main rate at 19%. The same bill that ushered that pause in, also introduced a higher 25% rate creating a two tier corporation tax structure, which will take effect from April 2023. The higher rate will be applied to companies with non-ring fenced profits over £250k. Companies with profits of £50k and under will pay the main rate of 19% and companies with profits between £50,001 and £250k will pay a tapered rate providing a gradual increase in the effective Corporation Tax rate. This change to corporation tax rules only makes the argument for full salary through PAYE even stronger.
So, collectively these changes mean that whilst Limited Companies often do remain the most tax efficient vehicle, when setting up in business the decision is far from as clear and simple as it may previously have been. We would therefore always recommend seeking professional advice before incorporating as a limited company, to ensure whatever model you choose suits your long term personal and commercial ambitions.