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In 2013, there were nearly 1.4 million Limited Companies in the UK. Out of these, nearly 600,000 were one-man band Limited Companies or companies with only one employee. In the past few years, the number of Limited Companies has been constantly on the rise. One of the key factors behind this increase is the greater tax-saving potential of running a Limited Company as opposed to full-time employment. In this article of "Path of Education for New Contractors", we look at the ways in which Limited Company Contractors can save on taxes.
As a Limited Company Director, you can pay yourself a lower salary and higher dividends. With this method, you can save on the National Insurance contributions and also reduce tax payments.
For the tax year 2014-15, you must pay Class 1 National Insurance contributions both as a Company and as an individual, if your income exceeds a certain limit. For employees with weekly wages of more than £148 per week, companies have to deduct National Insurance of 13.8% of salary. Similarly, employees need to pay National Insurance of 12% if their income is between £149 and £797 in a week. Therefore, you should keep your salary below £148 per week or £7,696 a year (148 x 52) if you wish to save on both employer and employee National Insurance contributions.
In addition, for the tax year 2014-15, the personal allowance for an individual tax payer is £10,000, so if you keep your salary below £10,000, you don't have to pay any tax on this income either.
You don't have to pay any National Insurance on dividend income and you can take advantage of the dividend tax credit, which can provide some tax savings in comparison to salaries.
In the UK, all businesses with a turnover above £81,000 should compulsorily register for Value Added Tax (VAT). You need to charge VAT to your customers at a flat rate of 20% of sales, and pay the collected amount to the HM Revenues and Customs (HMRC).
Example 1: Let's say you are billing your client for £10,000. If your turnover is above £81,000 in a year, you are required to collect VAT from the client, and so you bill the client for £12,000, which includes £2000 VAT (20% of £10,000).
However, with a flat rate VAT scheme, some Limited Companies can get some tax savings on VAT because of a legal loophole. To qualify, your business should be in the category of a flat rate VAT scheme and should have an annual turnover of less than £150,000. If your business is eligible, you may not be required to pay the full 20% VAT to HMRC. Instead, you to pay VAT at pre-decided rates. For example, for journalism-related services, the flat rate for VAT is 12.5%, or for computer repairs, the flat rate for VAT is 10.5%.
Example 2: Continuing with the above example, let's say you offer computer repairing services to your customers. You have collected £2,000 VAT from the customer. However, under the flat rate VAT scheme of 10.5%, you need to pay only £1,050 (10.5% of £10,000) to the HMRC, and thus keep the remaining £950 for yourself.
You can check here if your business is eligible for a flat rate VAT scheme, and the applicable rate of VAT for your business.
A Limited Company can deduct business-related expenses from its income. This way, you can save on the Corporation Tax payable on profits. You can deduct almost all expenses, as long as the expenses are incurred for business. Examples of such expenses are telephone costs, business travel expenses, stationary expenses, computer hardware and software, marketing costs, etc. However, it is important to keep receipts and proof for all business expenses.
Example 3: Let's say your business has earned revenues of £20,000 but you have incurred business-related expenses of £15,000, you will have to pay corporation tax only on £5,000.
Although you can deduct all of the expenses from your income, you cannot deduct expenses incurred on any purchases of assets such as computers. That's because the purchase of assets is part of the balance sheet, and not the profit and loss statement used for calculation of taxable profits. However, under the Annual Investment Allowance (AIA), you can get 100% allowance for the purchase of some assets and deduct these amounts from your profit. AIA can be applied to office equipment, computers, and building fixtures, but not to cars.
Example 4: Let's say your business has made sales of £40,000 and incurred business-related expenses of £20,000. Additionally you have purchased some office equipment worth £10,000. Using the AIA benefit, you can include this £10,000 as expenses and save Corporation Tax, normally payable on this amount.
In the early 90's, many full-time employees started operating as Limited Company contractors to get tax benefits. Whilst they continued to get all the benefits available to employees, they simply changed their legal status from employee to Limited Company contractors. This way they got the security of full-time employment along with the tax benefits of a Limited Company. To counter this, the government introduced the IR35 legislation. If contractors are caught inside of IR35, they have to pay all the taxes they may have saved through this method, and sometimes even more.
This can be a big setback from a tax point of view. To avoid this, you need to evaluate each of your contracts carefully. The contracts should not indicate that you are controlled by the client. Examples of such clauses in a contract include a requirement to complete fixed working hours or clauses stopping you from working with another client. Also, there should be no clauses around fixed payments. Instead, the payments should be on the basis of completed and approved work.
If you add your spouse or other family members as shareholders, you can split the dividend with them and get some tax savings.
Example 5: Let's say you are the only shareholder in your Company, and you have taken a net dividend of £45,000 (or a gross dividend of £50,000). The tax on this gross dividend works out to £1,832. However, if you add your spouse as a 50% shareholder to your company, both of you will get dividends of £25,000, which won't involve any extra tax.
If you set up a pension fund for yourself, the contributions made towards such pension are free of Corporation Tax, personal income tax and National Insurance. You can invest up to £40,000 in a year and up to £1.25 million in pension in your lifetime. Pension provides you with an ideal combination of tax efficiency as well as retirement funds.
You should submit your accounts to HMRC on time and ensure timely filing of tax returns. If not, you may end up paying fines, which could reduce your tax savings. For example, if you delay the filing of tax returns by a single day, it can cost you £100.
As you can see, a Limited Company can save tax in many ways. You can check the services of Account Direct, who can help you with all your accounting needs, including personalised advice on how to save taxes. If you are interested in contributing to a pension fund, check out Contractor Financial's pension services.
You may also find the following contractor calculators useful for your salary and tax calculations.