Now that the dust has settled on the 2004 Budget, the question many small businesses will be asking is: exactly how better or worse off are we? Well, the short answer is that although the Budget wasn’t great, it could’ve been a lot worse. After all, chancellor Gordon Brown resisted the temptation to crank up business taxes to pay for costly public service commitments.
With an election on the horizon, most analysts were not surprised that the chancellor did not rock the boat too much in order to keep the voters satisfied. However, although the spectre of higher business taxes has, at least for now, been banished, if you are a sole trader looking to incorporate for tax reasons, things aren’t as bright as they were before.
The reason, of course, is that small limited companies will have to pay a tax on ‘distributions’, i.e. dividends. Although, in true politician style, the news wasn’t as bad as what Brown hinted at during the pre-Budget report, the fact is that corporation tax is effectively at 19 per cent at all levels of profit to £300,000. A small amount of relief being available if you do not distribute all your profits in the tax year.
Described as a measure to stop the self-employed incorporating to avoid paying tax, the chancellor has neutralised the current 0 per cent band of corporation tax profits at £10,000 - unless you re-invest the profits in your business.
In practice, what this 19 per cent dividend tax means for small firms is:
If you have taxable profits of £10,000, you will currently pay no corporation tax on distribution of this via a dividend. However an extra charge of £1,900 will now be made, to make to total tax paid 19 per cent.
If you have taxable profits of £20,000, you will currently pay corporation tax of £3,375. If you distribute the full £20,000 you will need to pay total corporation tax of £3,800 (19 per cent), so an additional corporation tax charge of £1,425 would arise on distribution.
If you have taxable profits of £30,000 you will pay corporation tax of £4,750. If you decide to distribute £25,000 and retain £5,000 in the business, no additional tax is required as the average rate of tax is 19 per cent. If the additional £5,000 is required to be distributed a further £950 will need to be paid.
You have taxable profits of £60,000 and pay corporation tax of £11,400, whatever amount of profit you distribute, you will already be paying an average rate of corporation tax of 19 per cent, and therefore no more corporation tax is due whatever is distributed. Income taxes may well apply if you are a higher rate taxpayer.
Of course, these calculations are based on what the chancellor announced yesterday and, like most Budgets, details and amendments are tacked on in the following months, often with little publicity.
One potential problem for small firms has already emerged, with a provision to levy additional tax on companies who pay a dividend in excess of their profits for the year (for example, if you pay a dividend out of profits for previous years).
Although the details on this are not yet clear, it is believed that the measure will remove any tax savings on re-investment further down the lin. In effect, entrepreneurs will pay at least 19 per cent on all company profits in the long run.
So what can I do to avoid being hit by this tax?
The easiest way to get around the tax if you have profits under £50,000 per year is to pay out a big a dividend as you can before the rules come into force on 1 April.
However, remember that this dividend needs to be formally declared and paid out of distributive reserves with the appropriate minutes made. You should of course be careful not to over-stretch your business by making the payment too large, although there is nothing to stop you loaning this money back to your company if you have liquidity requirements.
Is it still worth being an incorporated business?
The tax benefits of being a limited company have been cut down by the Budget, and many small firms will feel aggrieved that after encouraging them to incorporate a few years ago, the chancellor is looking to ‘trap’ them in a dividends tax.
Despite this, in terms of taxation it is still better to be a limited company than a sole trader in most circumstances. The table below demonstrates this, assuming a limited company with one owner/director, taking a minimum salary and distributing the remaining profits fully as a dividend.