If you’re a business owner, contractor, or entrepreneur, you’ve probably wondered whether setting up a limited company could improve your tax position.
Many people have heard that limited companies offer tax advantages. Still, it’s unclear how they work or whether they’re right for your situation.
In this blog, we’ll break down how limited companies are taxed in the UK. Then go on to discover how this differs from personal tax, and the key factors you need to consider when deciding whether to use a limited company for tax efficiency. By the end, you’ll better understand the benefits and drawbacks of making an informed decision.
How Limited Companies Are Taxed
Knowing how they are taxed is essential to understand whether a limited company is right for you. When you operate a limited company, your business is treated as a separate legal entity from you. This means the company is subject to its taxes, primarily through Corporation Tax. Let’s dive into the details:
Corporation Tax
When you run a limited company, you’ll pay Corporation Tax on the company’s profits. This is one of the key differences between being self-employed (where you’re taxed on your income) and running a company. As of 2024, the main rate of Corporation Tax for profits up to £50,000 is 19%, and a higher rate applies if profits exceed that threshold.
To calculate the tax, the company first deducts its allowable business expenses—such as employee salaries, office costs, equipment, and other day-to-day operating expenses—from its revenue. The resulting profit is then subject to Corporation Tax.
For example, if your limited company makes £80,000 in profit in a year, it will be taxed 19% on the first £50,000, and the rest will be taxed at a higher marginal rate. The effective tax rate on these profits is usually lower than the progressive rates you face with personal income tax.
Dividend Tax
After paying Corporation Tax, limited company owners can distribute the remaining profits as dividends. This is a major reason why many people look to form a limited company. Dividends are taxed at a lower rate than regular income.
As of 2024, dividend tax rates start at 8.75% for basic-rate taxpayers, 33.75% for higher-rate taxpayers, and 39.35% for additional-rate taxpayers.
You also get a tax-free dividend allowance of £1,000, meaning you can receive this amount without tax. However, dividends can only be paid from profits after Corporation Tax, so they can’t be used to reduce your company’s Corporation Tax liability.
One key advantage here is that dividends are not subject to National Insurance—more on this later.
VAT (Value Added Tax)
If your limited company’s turnover exceeds £85,000 annually, it must register for VAT. VAT adds another layer of complexity, but it can also offer advantages. Your company may reclaim the VAT it pays on business purchases, reducing overall costs.
Different VAT schemes are available, like the Flat Rate Scheme or the Standard VAT Scheme. Each has its own benefits depending on your business’s size and the type of services you provide, so it’s worth understanding these options or seeking advice from a VAT expert.
Employer’s National Insurance Contributions (NICs)
If your limited company employs staff (including yourself as a director), you must pay the Employer’s National Insurance. For the 2024/25 tax year, employers must pay 13.8% on earnings above £9,100 per year. This is an important factor to consider, as it adds to the cost of paying a salary from your limited company.
How Limited Company Tax Differs from Personal Tax
Now that you know the basics of how limited companies are taxed, let’s look at how this differs from personal tax.
Income Tax vs. Corporation Tax
When you’re self-employed or work as an employee, you’re taxed on your income at progressive rates: 20% (basic rate), 40% (higher rate), and 45% (additional rate) depending on how much you earn. This can add up quickly, especially if you’re in the higher tax bands.
In contrast, limited companies pay a flat rate of Corporation Tax, currently 19% for most small to medium-sized businesses. This often results in a lower overall tax burden, particularly for higher earners.
For example, if you’re earning £100,000 as a sole trader, a significant chunk of that income will be taxed at 40% or even 45%, depending on your total income. In contrast, if you run a limited company, you could pay yourself a lower salary (which falls within the basic income tax rate) and take additional profits as dividends, which are taxed more favourably.
National Insurance Contributions (NICs)
This is one of the biggest differences between personal and limited company tax. National Insurance Contributions (NICs) are payable on your salary if you’re employed or self-employed. Still, dividends paid from your limited company are exempt from NICs.
This offers significant tax savings for company directors. For instance, you could take a low salary just above the National Insurance threshold and then take the rest of your income as dividends, avoiding National Insurance on the bulk of your income.
Dividend Tax vs. Self-Employed Income Tax
All your profits are subject to income tax and NICs if you’re self-employed. However, in a limited company, you have more flexibility. Once you’ve paid Corporation Tax on profits, you can distribute the remaining profits as dividends, taxed at a lower rate than income tax and free from NICs.
For example, if your business generates £70,000 in profit, a self-employed individual would pay income tax and NICs on the entire amount. However, it operates as a limited company after paying Corporation Tax. You can take the remaining profit as dividends, benefiting from lower tax rates.
Key Considerations for Using a Limited Company to Improve Your Tax Position
After covering the basics, let’s discuss the factors you should consider before deciding whether forming a limited company will improve your tax position.
Income Level
The most important factor is your income level. Generally, if you’re earning over £50,000 per year, operating through a limited company can result in significant tax savings. The combination of Corporation Tax and dividend tax is often lower than the income tax and National Insurance that a sole trader or employee would face.
However, suppose you’re earning less than this. In that case, the administrative burden and accountancy costs of running a limited company may outweigh the tax savings.
Splitting Income
One advantage of running a limited company is the ability to split income. You can issue shares to family members—such as a spouse or partner—and pay them dividends. This allows you to reduce the overall tax liability, particularly if your partner is in a lower tax band or doesn’t use their tax-free dividend allowance.
For instance, you’ll pay tax on all dividends if you’re the sole shareholder. But if your spouse owns half the shares and is in a lower tax bracket, you can allocate some dividends to them, reducing the overall tax burden.
Retaining Profits
Another advantage of a limited company is the ability to retain profits within the business. You don’t need to take all the profits out as dividends, which means you can defer tax. The retained profits can be reinvested in the business or used later when withdrawing them may be more tax-efficient.
This is a major benefit for growing businesses, as it allows you to avoid the higher rates of personal tax while reinvesting in your company’s growth.
National Insurance Savings
As mentioned earlier, National Insurance savings are a significant factor. Since dividends are not subject to NICs, you can structure your salary and dividends to minimise the amount of National Insurance you pay.
For example, many company directors take a salary that falls just above the National Insurance threshold (currently £12,570), which keeps them within the personal allowance while also paying minimal NICs. They then take the rest of their income as dividends, which are not subject to NICs.
Company Expenses
Operating a limited company also gives you more opportunities to claim allowable expenses, which can reduce your taxable profit. Common allowable expenses include business travel, office equipment, and salaries for employees (including yourself).
You can also deduct pension contributions made through your limited company, reducing the Corporation Tax bill while allowing you to build a tax-efficient retirement fund.
Potential Drawbacks of Using a Limited Company
While limited companies offer many tax advantages, some have better options. Here are some of the potential drawbacks you should be aware of:
Administrative Burden
Running a limited company comes with more administrative responsibilities. You must file annual accounts, submit a Corporation Tax return, and comply with PAYE and National Insurance requirements if you pay salaries. These obligations can be time-consuming, and failing to meet them can result in penalties.
Higher Accountancy Costs
Because of the increased complexity of running a limited company, accountancy costs are typically higher than for sole traders. You’ll need to file statutory accounts with Companies House and potentially register for VAT if your turnover exceeds the threshold. These additional compliance requirements mean you’ll likely need professional help, which adds to your operating costs.
Loss Relief
If your business makes a loss, loss relief is more limited for a limited company compared to a sole trader. Self-employed individuals can offset business losses against their other personal income, potentially reducing their overall tax bill. However, with a limited company, losses are generally carried forward. They can only be used to reduce future company profits, not your income. This could impact your cash flow if your business experiences an unexpected downturn.
When It Makes Sense to Use a Limited Company
When does it make sense to use a limited company? While many factors come into play, the following situations are when you’re most likely to benefit from incorporating:
You’re Earning Significant Profits
Running a limited company can offer significant tax savings if your business is making substantial profits, especially over £50,000 annually. You can reduce your income tax and National Insurance liability by paying a lower salary and taking the rest as dividends.
You Want to Split Income
If you want to reduce your overall tax liability by sharing dividends with a spouse or family member in a lower tax bracket, a limited company provides the flexibility to do so. This is an effective way to maximise household income without pushing yourself into higher tax bands.
You Want to Reinvest in the Business
If you plan to reinvest profits into your business, a limited company allows you to defer some personal taxes. The profits can remain within the company to fund growth, be used for business expenses, or be saved for future distribution when it’s more tax-efficient.
You’re Planning for Long-Term Wealth
A limited company can also be a useful tool for long-term wealth planning. For example, making pension contributions through your company can be tax-efficient in extracting value from your business. These contributions can be deducted from your company’s taxable profits, reducing Corporation Tax while building your retirement fund.
You’re Operating Multiple Ventures
Using a limited company structure can simplify your tax affairs if you have several streams of income or multiple businesses. You could even set up a holding company that oversees multiple limited companies, each benefiting from the corporate structure’s tax advantages.
Conclusion: Is Forming a Limited Company Right for You?
The decision to form a limited company is not one to be taken lightly. While there are clear tax benefits—such as paying lower rates on dividends, saving on National Insurance, and retaining profits within the company—additional responsibilities and costs must be considered.
You should weigh the tax savings against the administrative burden and higher accountancy fees and how much you expect to earn and reinvest in the business. A limited company can provide greater tax efficiency and flexibility for many business owners and entrepreneurs. Still, it’s always best to seek personalised advice from an accountant or tax professional.
Ultimately, whether a limited company is the right choice depends on your financial circumstances, future business plans, and long-term wealth goals. Exploring your options and making an informed decision can set you up for long-term success and greater tax efficiency.
Leave a Reply