Tax issues unpicked: part two – self-employed versus limited companies
Shoaib Khan explores the tax questions associated with both self-employed dentists and those working for limited companies.
September is usually the time of the year when many dentists will start their careers as associates. For many of them, it will be the first time they become self-employed. This means the responsibility for reporting their income and expenses is on the individual.
At this stage in their career, a dentist can choose how to operate. The most common tax question I am asked by new associates is: ‘Should I operate as a sole trader or via a limited company?’ Often, the answer to this question is: ‘Well, it depends…’
The answer varies depending on individual circumstances. This article aims to highlight some of the key implications for an individual (both tax and non-tax related) and provides guidance for new associate dentists.
I have set out below the various tax rules of relevance, with a basic example to illustrate how these might apply to an individual.
The basics first
As mentioned in the previous article in the series, each individual must register to complete a tax return via the HMRC website. If you have not done this already, I would encourage you to register as soon as possible. Due to the COVID-19 pandemic, HMRC responses are delayed. This may result in you not registering in time for the filing deadline (ie 31 January 2021 for 2019/20 tax year).
Good record keeping is very important. It is also a legal requirement for both sole traders and companies. Your tax adviser should be able to assist you in this respect. However, recording keeping is your responsibility.
How are the profits taxed?
Self-employed: a sole trader pays income tax, Class 2 and Class 4 national insurance contributions (NICs) in respect of their profits. As a rough guide, the combined rates of tax and NICs for profits are:
- From £9,500 to £12,500 – 9%
- £12,500 to £50,000 – 29%
- £50,000 to £150,000 – 42%
- and above £150,000 is 47%.
Limited company: the company pays corporation tax (CT) on its profits as they are earned. The current rate of corporation tax is 19%. There is a second layer of tax (ie personal tax) payable when the director (who is also the shareholder in an owner-managed limited company) withdraws some or all of the after-CT profits from the limited company. There is a degree of flexibility as to how and when the profits are paid to the director/shareholder of a limited company.
When is the tax due?
Self-employed: the general rule is that the tax and NICs due for a tax year is payable by 31 January immediately after the end of the tax year.
In addition, payments on account (POAs) are required by 31 January during the tax year and 31 July immediately after the end of the tax year. Where the tax liability exceeds the sum of the POAs, a balancing payment is due by 31 January, immediately after the end of the tax year.
Limited company: corporation tax is due nine months and one day after the end of an accounting period. If the director/shareholder takes income from the company, they will also need to pay income tax. The due dates are the same as above for the self-employed individuals.
What are the reporting requirements?
Self-employed: the sole trader must register with HMRC and from there on, submit a personal tax return each year. For the sole trader, only three figures need to be returned to HMRC: income, expenses and profit/loss.
Limited company: the company must be registered at the Companies House. It must prepare annual statutory accounts in the format prescribed by the Companies Act. Those accounts must be filed at the Companies House.
The company’s accounts and other filings at the Companies House forms part of the publicly available information. They can be viewed on gov.uk by members of the pubic.
The company must also submit an annual corporation tax return to HMRC, including supporting calculations. The director/shareholder reports any income received from the company in their personal tax return.
Overall, there are additional admin requirements for a limited company, resulting in higher accountancy costs.
Let’s look at the numbers
For the purposes of this article, let’s assume that the earnings are £63,816 per annum (ie the average annual salary for an associate dentist as per the NHS website). The annual expenses include membership fees for GDC, BDA, professional indemnity, and professional development courses (including travel and accommodation costs for courses attended). In essence, the type of allowable expenses typically incurred by dentists.
The expenses add up to £3,816. This would leave a profit subject to tax of £60,000 (ie annual salary of £63,816 less expenses amounting to £3,816).
- The tax return period for both sole trade and the accounting period for the company in this example will be 31 March 2021. The tax rates for 2020/21 for England apply
- The income has not been adjusted for working part of the year. Rather to make the comparison simpler, a full year of profits are used.
The table below set outs a high-level calculation of net cash available after tax under both scenarios, ie sole trader versus a limited company.
|Sole trader||Limited company|
|Additional accountancy fees||-£1,200 (1)|
|Corporation tax (@ 19%)||n/a||-£9,502|
|Income tax (@20%/40%)||-£11,500 (3)||-£2,652 (4)|
|Class 2 NICs (£3.05 per week)||-£159|
|Class 4 NICs||-£3,845 (5)|
|Net cash||£44,496 (6)||£47,360 (7)|
- This is an estimated amount; the accountancy fee will vary depending on your tax adviser
- The maximum salary that can be paid without triggering a tax or NIC for 20/21 tax year is £8,788.
- There is a personal allowance of £12,500 available to each taxpayer for income tax purposes. The next £37,500 is taxed at 20% and anything above, up to £150,000, is taxed at 40%
- A popular tax-efficient profit extraction strategy used by personal companies is to take a small salary and extract further profits as dividends. In the example above, all profits after-CT are taken out as dividends. The 2020/21 dividends are taxed at 7.5% up to £37,500 and 32.5% up to £150,000 taxpayers. There is a separate tax-free allowance of £2,000 for dividends
- Self-employed individuals are liable to Class 2 and Class 4 NICs. Class 4 NICs are taxed at 9% on profits between £9,501 – £50,000, and 2% on profits over £50,000. This is payable together with your income tax
- Personal tax return and the payment in relation to the example will be due on 31 January 2021. The first payment on account in relation to 2021/22 tax year will also be due on this date
- Company accounts will be due for submission to Companies House by 31 December 2020. Corporation tax payment will be due by 1 January 2021 and corporation tax return will be due by 31 March 2021. In addition, the personal tax deadlines above in note six will also apply in respect of the salary and dividends taken from the company during the year.
Some other considerations
In the example above, the company option appears to be favourable as the individual is £2,864 better off. However, it is assumed that the associate opted out of the NHS pension scheme. Under the current rules, the NHS will not make pension contributions for associates operating via a limited company.
Therefore, you will need to weigh up the benefits of potential tax savings versus losing out on the NHS pension. Professional advice from an independent financial adviser should be taken in this respect. This is a very personal decision.
In my opinion, the main advantage of operating as a limited company over a sole trader is that the corporate structure gives you flexibility in how much income you take out of the company. In the example above, we’ve taken out all the after-CT profits (£49,298) from the company.
But what if the associate decides that £30,000 is sufficient for them for a particular year. The remaining profits will stay in the company without further taxation.
A word of caution though; if your trading profits are at a level below the profits in the example above, then the extra taxation elements of operating a company would make this an unattractive option from a tax perspective.
This article should provide useful guidance for newly-qualified associate or experienced associated contemplating their options. Individuals must consider their specific circumstances before deciding on how to operate. Finally, it should be noted that if your circumstances change, it is always possible to change how you operate.
Next in the series
In the next article of this series, I will review the tax issues when buying a dental practice.