The effects of company formation and tax efficiency and savings will depend on individual financial characteristics and the specific circumstances pertaining to the situation.
The example provided below where the overall tax liability is reduced is for general illustrative purposes only and should not be taken as a substitute for the appropriate professional advice.
Comparing a Company Director to a Sole Trader
A director of a company and a sole proprietor might have several elements in common.
They may (certainly in the latter case), both be the single owner of the business they run and also made the decision at sometime in the past consider the type of entity they wished to carry on their trade.
One chose to operate as a sole trader, whilst the other decided that forming a company was the better option.
Sole Traders and Tax
Sole traders and their business are deemed to be the same “person” as far as the taxation system is concerned.
In a year where the business earns £100,000, the full amount is classed as the sole trader’s income for that period.
They are then taxed (subject to personal and other allowances) on the full amount whether or not any of this money has been withdrawn and spent.
The disadvantage here is that in situations where the sole trader retains some or all of the profits within the business to buy more stock for example, that retention does not reduce their income or their overall tax liability.
Company Directors and Tax
The tax effects of forming a company can be seen as follows. Directors are seen in law and by the tax system as separate from the company which they may run and own.
As such each is taxed as if they are not related. Thus a company making the same profits of £100,000 would be charged as follows:
Any salary payments to the director would be a deductible expense from its profits.
The director would only be taxed on the amounts remitted to them and not on the full amount.
A Simplistic Example of Tax Savings
Sole Trader with income of £100,000
Personal Allowances (£5,225)
Taxable Income £94,775
Tax Liability
- on 10% Band £223
- on 22% Band £7121.40
- on 40% Band £24070
Company Director with income of £100,000 (withdrawing £60,000 as salary)
Personal Allowances (£5,225)
Taxable Income £54,775
Tax Liability
- on 10% Band £223
- on 22% Band £7,121.40
- on 40% Band £8,070
The Company's tax liability is £60,000 @ 20% £12,000
Total paid by the sole trader = £31,414.40
Total paid by the director and company = £27414.40
Total Tax Savings £4,000
