August 18, 2020 Limited Company vs Sole Trader – The Power of Retained Profits Deciding whether to run your business as a sole trader (self employed) or a limited company can be a difficult decision because there are so many factors to consider – both tax and non-tax. In this article we are going to focus on just one of the key benefits of a limited company, which is the ability to retain cash in a company tax free. When you are a self employed sole trader you will pay income tax (and national insurance) based on how much profit your business has made in a tax year – regardless of whether you need all of the cash generated or not. However, when you trade through a limited company you have much more flexibility – your company will pay corporation tax on the profits that it generates – but you personally will pay income tax based on how much money you choose to extract from your company (salary and dividends). This can be a significant benefit of a limited company and one that is often overlooked. Below we work through some example circumstances where this flexibility can be useful. Example 1 – fluctuating profits year to year In our first example we’ll look at a business whose profits often fluctuates year to year – let’s assume that this business is being run as a sole trader and in year 1 it makes £80,000 of taxable profits and in year 2 it makes £20,000 of profits, so £100,000 over the two years. Using the 2020/21 UK tax rates and assuming the tax payer doesn’t have any other income to consider, the taxes across the two years would be as below: We can see from the above that across the two years the total tax and national insurance is £26,507, which leaves £73,493 after taxes. Now we’ll compare this to exactly the same business that is being run as a limited company with a tax efficient salary. In this scenario we have equalised the amount of dividends paid to be the same across the two years because the business owner knows that year two’s profits will be much lower than year one. You can see from the above table that in this scenario the business owner has chosen to leave £24,300 of retained profits in the business at the end of year one to enable them to support year two dividends. In this case the take home pay after factoring in all taxes across the two years is £80,179 – this is £6,686 less tax across the two years than the sole trader scenario. The reason the difference is so large is that in the limited company example the business owner has chosen not to take as much dividends as they could have done in year one in order to support year two dividends – essentially they have smoothed out their dividends between the two years rather than having higher dividends in year 1, some of which would be taxed at the higher rate of dividend taxation which is 32.5% compared to 7.5%. Let’s take another look at this limited company example and see what it looks like if the business owner extracted maximum dividends in each year rather than smoothing out the two years: You can see from the table above that in this scenario the take home pay across the two years is £76,062 which is over £4,000 worse than if the dividends were ‘smoothed’ out across the two years. It is still more tax efficient than the sole trader example, but the difference is now only £2,569 (£1,285 per year). Example 2 – building up profits in the business The first example looked at a small business owner who chooses to smooth out their dividends across the two years but ultimately they still extract out all of the dividends that they could do, leaving the company with no spare retained profits at the end of the second year. In this second section we look at a very powerful tool for both tax efficiency and the financial strength of your business – building up retained profits. Assuming you are the only director & shareholder of your limited company then you can choose exactly how much dividends to pay yourself from your company – if you choose not to extract out as much dividends as you could do, not only are you potentially reducing your personal income tax but you will also be strengthening the financial position of your company. This is a particularly timely topic due to the worldwide COVID-19 pandemic that is severely impacting many businesses. A business that has built up a sizeable amount of retained profits will be in a stronger position to survive a downturn – not only does it give the company a cash buffer to help it to continue to operate but this breathing space may also allow the company to make better long term decisions as it won’t have the short term pressures of cashflow that a business with less retained profits may have. Building up a warchest of retained earnings can also allow a business to take advantage of opportunities as they come along – for example purchasing some new expensive equipment that will help the business operate more efficiently. Let’s now look at an example – in the below scenario we look at a sole trader that makes £60,000 of profit and compare it to a limited company making the same profit – but in the limited company scenario the director/shareholder has chosen to extract only £30,000 of dividends because they don’t need more than that and want to build up some retained profit in their business. In the above tables you can see that in the sole trader example the total tax and national insurance paid is £15,504 – this compares to the total taxes in the limited company example of £11,555, almost £4,000 less tax. Choosing to restrict your dividend extractions can be a particularly tax efficient strategy if leaving some cash in your business enables you to personally stay within the basic tax band rather than having some of your income in the higher tax band. Company cash balances and the FSCS One consideration to bear in mind if you are building up a sizeable cash balance in your company is the Financial Services Compensation Scheme (FSCS). Currently the FSCS protects up to £85,000 per bank if the bank fails and can’t pay back your money. If your business bank balances are in excess of this it might be worth setting up another bank account with a different banking group, so you spread your money across multiple banks to get extra protection. For more information on this please see the FSCS website below: https://www.fscs.org.uk/ Investing company cash One downside of building up cash in a company is that you may find it difficult to get a decent interest rate on your business savings account and there are also more restrictions on being able to invest money via a limited company than to do it personally. It’s generally not a good idea to make investments via your businesses limited company as it can cause HMRC to treat your company as an investment company, rather than a trading company, which can have various tax consequences – but this is a very detailed topic which we won’t be covering in this article. If you were considering using company retained profits to make investments then you may want to consider the option of instead making employer pension contributions direct into your pension scheme – depending on your pension scheme you can then choose how you invest this money (e.g. individual shares, funds etc.) – these company pension payments would usually be treated as allowable costs for corporation tax purposes which would reduce your companies profit & corporation tax liability. There are many rules and details to be aware of with this strategy so we would highly recommend you discuss this with a qualified pensions advisor before making any decisions. Dividends and retained profits When it comes to extracting dividends from your company a key point to bear in mind is that dividends can only be paid if there are sufficient cumulative post tax retained profits in the business – it is illegal under company law to pay a dividend if there are not sufficient retained profits – make sure you have factored in all liabilities including a running corporation tax estimate for the current period before assessing the retained profits position. Flexibility of a limited company During this article we have explained how using the flexibility of a limited company structure can enable you to save tax by choosing when you extract dividends out of your company, and it can also allow you to build up the financial strength of your business. In our view this is one of the most underestimated benefits of a limited company structure, but everyone’s circumstances are different so we would always recommend discussing your business structure and tax planning with a suitably qualified accountant.