Start Me (Company) Up
Following my previous post, I’ve had a couple of emails from people thinking of switching from self-employment to limited company status, so I thought I’d whizz over the info I harvested when making the decision, in case it proved useful, for translators specifically. Needless to say, I’m not a qualified accountant or lawyer, so don’t rely on what I say as the be all and end all. Everybody’s circumstances are different. I think my situation is probably fairly simple – I have income only from translation, I work from home (no travel/car for business, which does add complexity), my tax code is ‘normal’, and so on.
Given that “tax efficiency” is often a motivating factor behind the decision to change status, most of this post will deal with the financial comparison. This post originally had almost no figures – on reflection I actually believe it’s clearer to include them, so I now have. The thresholds and percentages are all for the just-ended 2011-2012 financial year.
Self-employment
As I’m sure any s/e people will know, the financial maths itself for basic self-employment is fairly straightforward.
The invoices sent out are your gross income (accrual basis these days, not cash).
From that you can deduct business expenses and allowances (more on allowances later).
The result is your “profit from self employment”, on which you then pay the following to HMRC:
a) personal income tax on earnings over your personal allowance (£7,475 being the standard allowance), at the basic rate of 20% on the first £35,000 and 40% over that, up to £100,000 (it does get complicated after that, with reductions in personal allowances and more tax bands, but I think we can disregard that for the purposes of this exercise, since unless you are proving a political point in a Boris or Ken way, if you’re on 100k and haven’t got a limited company already…).
b) Class 4 National Insurance on profit from self-employment (the same figure as above, so yes, this is effectively a second tax on the same money) at a rate of 9% on that profit between £7,225 and £42,475, and 2% on profit over that level (ad infinitum, AFAIK).
The observant will note that the figure where Class 4 NI contributions drop to 2% is the same as the upper threshold for basic rate income tax + the ‘standard’ personal allowance. So a quick and dirty tax+NI combined calculation could be that from your profit from self-employment, the first 7,400 or so is tax free, you pay 29% on the next 35k, and 42% after that.
Moving away from quick and dirty into the wholesome sphere of accurate number crunching for running a comparison, do not overlook the fixed rate class 2 NI which is another deduction from your earnings, but not a tax-deductible one. And was only £130 in 2011-12, but still…
Limited Company
Limited companies are a tad more complicated, because there are more variables, the main ones being how many directors and shareholders there are, and whether those directors draw a salary, and if so how much. However, the guidance for tax efficiency, disregarding other considerations, is that a director should draw a salary at a level whereby they pay a small amount of NI (for state pension entitlement purposes) but not enough to pay personal income tax.
Given that, the company’s gross income is your invoices, like before.
From the gross figure , you can deduct the business expenses, as before. However, you cannot deduct allowances for use of the home as an office to the same extent (I know some s/e don’t use this allowance fully or at all anyway, for fear of CGT liability later), so if doing a hypothetical comparison calculation, you need to add these allowances, if any, back in for the calculation. Furthermore, if you’re not already using an accountant as a self-emp’d person (I wasn’t), you will need to deduct a further business expense in accountant’s fees, which I think are inevitable in the first years of a limited company at least.
You will also need to deduct as a company expense, which you would not do under s/e status:
a) the salary paid to the director(s), likely to be = £7,475 (so the director’s personal income tax = nil)
b) and the (small) amount of employers’ Class 1 NI contributions being 13.8% on salary(ies) over £7,228.
That gives you a taxable profit for the company from which you then deduct company tax at 20% (small company rate).
After company tax has been deducted, you can pay up to the amount left (retained earnings) in dividends to the shareholder(s).
So, in terms of income for the shareholder/directors, if dividend payments are not high enough to push the individual receiving them into the higher personal income tax bracket (a simplification – there is a tax credit of 10%, and it is the notional grossed up figure on which this calculation is based, not the actual amount of dividend paid itself, which is taken actually be = 90% of the notional 100% figure), then you don’t pay personal income tax on them.
Summary
Certainly as things stood for y/e April 2012, then disregarding the minor differences in the thresholds and assuming no higher rate tax, as both company tax and basic rate income tax were at 20%, the saving made from operating as a limited company was very broadly equal to the 9% paid in Class 4 NI.
In summary: If self-employed, you’d take your profit from self-employment, and pay 20% income tax and 9% NI on the amount above £7,400-odd, as mentioned earlier.
If a company, you’d pay yourself a salary equal to your personal income tax allowance (£7,475), the company would pay 20% tax on its profits (after your salary is deducted as a cost to the company) and then pay dividends, essentially tax free, to you, up to £31,500 (=35k grossed up).
The 20% tax paid would be broadly the same, although paid by different entities; the difference is the 9% NI deducted for the self-employed.
Hence, even at relatively low income levels, assuming 9% of your earnings over £7,475 is not greater than any potential extra costs incurred (e.g. accountants, or lost allowances permitted under s/e), and assuming you are in a position to opt for reasonably tax optimised arrangements in terms of salary levels and shareholdings, it can still make real sense to change status.
You can find websites that will do these calculations for you, but one drawback I found was that they do assume the start point “net profit” figure is the same if you’re self-employed as it is as a limited company. Which it may not be, and in my case certainly is not – see comments about allowances earlier.
The other point to note is that the cash flow is almost certainly going to be different. As a self-employed person, I was used to just transferring money from the business account to my personal account as and when the fancy struck. While in theory a company can pay dividends as often as it likes, a) the directors have to pass a resolution and issue formal document vouchers, and b) ideally, there has to be a P&L drawn up showing that the company has sufficient cash reserves to pay a dividend. You can bypass this with directors loans accounts and suchlike, topped up by dividend payments subsequently, but in terms of keeping your head down and your nose clean, it doesn’t seem (judging from comments in accounting forums) that using such a facility regularly is a good idea.
Any questions? 🙂
You’re a clever boy. I switched to Ltd on the advice of my accountant, and I think that the more mathematically challenged amongst us need to take into account that they will almost certainly need to hire an accountant if switching to Ltd company status, as the paperwork is a lot more complicated (to me anyway – but then, I am Queen of all the mathematically-challenged people).
Absolutely, I believe I said as much, because that situation certainly applies to me. 🙂
I did my own books while self-employed. I’ll be using an accountant now, hence the extra cost to include in the calculation.
Thanks for the post; very informative.
Re the final paragraph, evidently you can no longer dip into business funds as and when you feel like it. Practically speaking, how does one proceed? I imagine you (i) take a set salary each month, and (ii) take a fixed amount each month for dividends, which are calculated on the basis of projected profit for the year. For (ii), if at the year-end it turns out that actual profit is more than you projected, I assume you can just take an extra dividend. But what if actual profit is less than projected, and you’ve already taken all the projected profit out as dividends?
I think the basic error there is “dividends… calculated on the basis of projected profit for the year”. Playing it by the book, dividends are only paid on actual profits that can be shown to exist by up-to-date accounts (and it must be said that even the worst of our tax-avoiding capitalist behemoths seem to stick to this rule, if no other!). And while you can pay dividends as often as you like, it seems you risk attracting attention if you do so more than quarterly.
If you pay dividends that are ultimately not covered by profits, you open yourself up at the very least to a world of extra admin in directors loans or having it deemed salary instead. This gives the general idea:
http://www.accountingweb.co.uk/anyanswers/question/company-made-loss-directors-allowed-dividends
That said, clearly every problem has a solution.
I like to keep things as simple as possible, though, so I expect to live off the earnings from self-employment until the company hits its stride, since although I’m no longer s/e, clearly the money (all accounted for in f/y 2011-12) will continue to hit my bank accounts for a few weeks yet. That said, the best laid plans… (and the euro’s edging in the wrong direction at precisely the wrong time!)
And my plan could well demonstrate how a little knowledge is a dangerous thing, and prove ridiculously naive.
Thanks for the further info. We’re approaching the nub of my question – and apologies if I’m being a little slow to grasp how this works.
If I understand correctly, then, you will live off your earnings from self-employment for a few weeks, by which time the company will have started generating some income. So, let’s project ourselves forwards two or three months – you have no more income from self-employment, and your company is earning money but can’t pay it out as dividends yet. And you’re only taking a salary of £7.4k a year. What do you live on in the meantime? Are you perhaps planning to take a quarterly dividend which, combined with the small salary, will give you enough to live on for three months until the next quarterly dividend comes around?
One of the implications one might draw from this is that it could be unwise to go limited unless one has a sufficient cash buffer set aside to sustain oneself for at least two or three months while the limited company gets up and running and starts earning some money.
Well, we are reaching the realms of my individual cash flow here, but essentially what you say is true, a cash buffer is probably required, and I have made sure I have one (I always do, it’s just a bit bigger at the moment), which is precisely what I plan to live on in the meantime.
We mustn’t overlook the fact that, ideally, the income will remain as it would have been, it’s just phased differently.
In my case, I typically only invoice at month-end, and the majoity of my clients wait a month before even thinking about paying. That means the money I’m spending today probably comes from work that was actually done in 2011 in some cases. I will definitely still be receiving money in June from work done in March while self-employed as well as from the more prompt payers from my first April limited company invoices. The s/e money I can just “dip” into and spend. The Ltd co money, I’ll have to wait and distribute a proper dividend.
It’s actually the second quarter where perhaps money might be a little tighter. any incoming s/e payments will have dried up, and the June (Q1) limited company dividend payment (which despite accrual accounting can only pay me cash it has actually received unless I am prepared to go overdrawn, which would be an option, I guess) is likely to be fairly small (albeit entirely tax free, no need to put any of it aside), This is really where I am expecting my s/e float or buffer to start getting used. By the end of Q2, I should be sitting on a full 3 month’s worth of income to be distributed as dividends, and from then on, everything should be relatively smooth with the difference that the bulk of our income is received quarterly, not monthly or whenever we feel like dipping 🙂
(I’m not sure I would actually recommend using it, but I’m sure that as a consciencious tax-payer, you’ll have put aside several thousand quid to cover your income tax, money that HMRC doesn’t actually need from you until next January….!)
OK, thanks Charlie, that’s much clearer now. Lots to think about…
Really interesting stuff, Charlie – and very clearly set out. However it’s not clear to me (at the moment) that it would be advantageous for me to go down the Ltd. route. All I can imagine is long afternoons talking to my accountant (not an enticing prospect) and not really understanding everything he tells me; compiling VAT returns every 3 months on invoices issued to clients living in other countries; keeping enough cash to one side to deal with the extremely late payers (most of my Italian clients pay at 90 days and longer).
But I’m going to save a link to this blog (is this a blog?) and check back periodically. You’re to be warmly thanked for taking the trouble to set this thing up and input all that useful information !
Yeah, I think it’s a blog 🙂 Not the most frequently updated blog in the world, but a blog nonetheless!
It’s probably fair to say that going limited is a decision that needs to be based on considerations other than purely financial ones. Lord knows I’m critical enough of decisions taken by those who know the price of everything but the value of nothing. I could counter your specific objections – if you’re not VAT registered now, you don’t have to be as a limited company, the rules are based on turnover, not status or legal form, and in any event you wouldn’t charge VAT to Italian customers (assuming they are businesses; on the other hand, you would need to do a European Sales List); and longer payment terms in theory ought to just mean than that your cash flow buffer would get used in Q3 rather than Q2, so assuming you’re not living hand-to-mouth now, these issues could be overcome – but I’m certainly not here to persuade the reluctant. 🙂
I’m all in favour of people doing what they’re comfortable with, not what they feel they ought. I read a blog a few days ago that implicitly unfavourably compared me to the antichrist, as I don’t charge extra for urgent jobs. Meh, as the kids would say!
I pay myself dividends every month according to the carried forward/distributable figure shown in my accounting software (operating profit minus up-to-date corporation tax and dividends paid), not using projections. Thanks to the same accounting software, VAT filing AND paying is done in one click. I believe it’s well worth investing in efficient tools – saves a lot of headaches.
Can’t argue with actual experience (I was going to say to Tom last night that sometimes I felt like I was writing a guide to the Amazon based on reading a Hardy Boys adventure) nor with your conclusion.
What software do you use? My accountant wants me to use VT Transaction Plus, which he reckons does as you describe. I really opught to have tried downloading it and playing with it. Don’t tell him I haven’t got round to it yet….
http://www.freeagent.com/
Best business investment I’ve ever made.
Have just stumbled across this very useful information, thanks Charlie and all contributors. I’m on the verge of “going limited” myself and am curious about a couple of salary-related things, so would appreciate any advice.
Firstly: if I pay myself a salary equal to my personal allowance (which for 2012-2013 is £8,105 as far as I can gather, and will rise to £9,440 from April onwards), will that affect my state pension entitlement later on down the line?
Secondly: as a limited company, how often do you pay yourself a salary? Do you set up a regular monthly payment from your business account (bearing in mind that a freelancer’s income will vary from one month to the next), or do you simply let the money roll in over the course of the year and then pay yourself a lump-sum salary at a given point? Cashflow is no problem for me as I’ve got enough cash to last me a year, it’s just that I’m wondering what to tell the bank when I set up my business account and salary.
And finally: as there will inevitably be a “transition period” when you wait for s/e invoices to be paid and wean your clients off the old bank account as you start invoicing as a Ltd., does it get horribly complicated when you do your tax return for the year when you go limited, when you have two sets of accounts to contend with? For instance, I wonder what happens with business expenses such as Internet, phone etc. Well, it would just be good to have a general idea of whether it’s horrible or not, I’ll ask my accountant for the lowdown in February but I’m loath to bother him now as he’s always drowning in work at this time of the year, with clients dumping huge mounds of completely unsorted paperwork on him and expecting him to turn their tax returns around on the double!
Hi Peter, glad it’s been of some help. Remembering I’m no expert, my answers would be:
1. I don’t know. The idea of this lark is primarily to reduce tax liability. The salary level is pitched, as you say, to avoid personal income tax, but that does mean you will pay a few quid in NI (unless you pay yourself that much less, but that would be less efficient in tax terms, because it would thus increase the company’s profit on which tax is paid). Whether that few quid will be enough for the year to count as a qualifying year for pension purposes I don’t know. I haven’t checked because I know you can top up your NI contribs to turn a non-qualifying year into a qualifying one (see http://www.hmrc.gov.uk/ni/volcontr/toppingup.htm). Part of me suspects I may never retire anyway….!
2. So far, once, of several thousand pounds to catch up a bit. I wanted to maximise dividends in the first 2 quarters (no devious tax efficiency there – just wanted to make sure the wife had some money!) so I paid no salary to myself. Apparently, though (i.e. my accountant said so!), I could have set the thing up from day 1 and just made no attempt to actually take money out the company until I wanted to. And indeed now the payslips are here, they show more money “paid” than I have actually taken as my salary.
I would disregard month-on-month fluctuations per se, because the salary level is actually very low, and if a translator can’t cover that every month, they probably shouldn’t be going limited 🙂
I would actually prefer to pay salary as and when I feel like it, but it seems that as from April 2013, monthly returns to hmrc are mandatory anyway, so if the paperwork is going to say I’ve had the money, I might as well take the money!
3. I went limited at the very start of the tax year, just to avoid complications. The company was formed a couple of weeks before I started trading with it. Doing it mid-year, I would imagine you would simply choose a date, and cease to be self-employed at that date, which is when your entitlement to claim s/e expenses for internet/phone or allowances for mortgage interest would effectively cease. In all honesty, if you’re going to see your accountant in Feb, I would just look to start operating as a company as of 1 or 6 April 2013 and save yourself some hassle. That is not professional advice, just bloke-down-the-pub advice 🙂
I see, many thanks Charlie! Hm, well… think I’ll just put my niggling concerns about my pension to the back of my mind. After all, tomorrow is another day (he said flippantly). Only 30 qualifying years are needed, and I must have built up roughly half that by now, so I can always switch back to being s/e in the dim and distant future if necessary, and if the voluntary top-up option isn’t possible or worth it.
Although I agree it kind of makes sense to wait until April to go limited, I’ve got a couple of large projects on the go and would rather like them to benefit, so I think I’ll just cross my fingers and take the plunge. But thanks for the bloke-down-the-pub advice on that point anyway 🙂 Once I’ve been up and running for a few months, I’ll find the relevant thread on ProZ and report back on my progress, so others can benefit from my newly-gained wisdom. Anyway, I’m glad things seem to be going pretty smoothly for you after the initial hurdle with the bank account. Am going to try Santander as they let you apply online and don’t charge for international transfers in. Happy New Year and thanks again for your reply!