Contractors Tax

Anyone with an inkling for entrepreneurial flair would be lying if they said that they had never aspired to owning their own business bringing in net profit of say £40,000 per  annum. The reality is that many have tried such a venture and have succeeded, only to find at the end of the financial year that they haven’t given a second thought to tax planning.

Let me tell you the story of Mike Smith, an unemployed IT consultant from Ipswich. Mike launched himself into a business venture as a self employed IT consultant 12 months ago, hopeful that he would a least be able to scrape a living. In his first three months of trading he turned over only £5000. At this point as, Mike considered talking to his local accountant to seek advice regarding tax planning, took one look at the potential cost and dismissed the idea outright!

Nine months later, Mike has become adept at finding IT contracts via online job boards and easily made a net profit 0f £40,000 for the year. The trouble is, that for this financial year at least, the horse has bolted and many tax planning opportunities have now faded into the distant past.

With a profit of £40000 (2010/11), Mike will be facing a tax liability of over £9447 (composed of income tax and Class 4 National Insurance).

However, if Mike had taken advice in the early stages of his business, he had the potential to save quite a large amount of tax. The first thing he should have done (with the benefit of hindsight of course) was to have formed a limited company. By forming a limited company, the profits would have fallen within the corporation tax regime and so he would have been liable to pay £7040 in corporation tax after having allowed for his salary, which I’m coming to next. Assuming that he hadn’t used his personal allowance elsewhere, he could then have paid himself a salary up to the personal allowance limit, resulting in an income tax liability of nil. There would have been a small amount of national insurance to pay amounting to approximately £60, but in the scheme of things, this is negligible. On the advice of his accountant, Mike then paid himself the remaining £26484 in dividends resulting in a further tax liability of absolutely nothing!

In summary, by not taking advice in the early stages, Mike’s lack of forward tax planning cost him over £2000. He can of course learn from his mistake, form a limited company immediately and take advantage of savings for the future.

But are things really as simple as this? The first problem that Mike will face will be that his level of income isn’t guaranteed and he may make less profit in the following year. Accountants also charge considerably more to process limited company accounts as they must comply with detailed legislation prescribed by law. The result could be that with lower income and increased operating costs, Mike isn’t any better off at all and he ends up lumbered with a dinosaur of a limited company that does nothing more than add pressure to his already stressful life.

The decision at the end of the day is based upon the delicate balance of risk and reward, i.e. the risk is that Mikes profits fall resulting in virtually no tax savings. The reward will be the savings made if profit don’t fall.

At the end of the day though, if a limited company turns out to be redundant, Mike could simply close it down and return to his life as the employed or even self employed individual the he previously was.