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Time to incorporate?

Autumn 2010

Changes to tax rates in April 2011 have increased the attraction for small businesses of trading as a limited company compared with self-employment, provided the owner draws income mainly as dividends.

The corporation tax rate for small companies fell by 1% (to 20%) in April, equal to the basic rate of income tax. At the same time, the main rate of national insurance for self-employed individuals increased to 9%, with 2% on profits above £42,475.

The new rates mean that self-employed people with profits of £60,000 could save over £4,400 by incorporating the business. To gain maximum benefit they would have to take a salary of up to £7,475 (the personal allowance) and draw further income as dividends. The saving results from avoiding national insurance contributions and from the lower rates of income tax on dividends compared with earnings.

More money can be saved at higher profit levels and by not drawing all the profit. Paying dividends to a spouse or partner whose income is below the higher rate tax threshold may produce further benefit.

But incorporation does not suit everyone. At low levels of profit the saving might not be worthwhile compared with the administrative costs and additional compliance needed. You might also have a problem if you change your mind. While there are tax reliefs on taking a business into a company, the opposite move can be costly.

It is also set to become more expensive to wind up a company. Normally, shareholders pay income tax of up to 42.5% on dividends. The exception is distributions in a liquidation, which are liable to capital gains tax (CGT), generally at 10%. At present, an extra statutory concession allows you to avoid the costs of a formal company liquidation and still pay CGT on distributions before the company's dissolution. However, draft legislation would impose a £4,000 limit on distribution that qualify for CGT. No date has been set for the change.

If you are looking for investment into your business, changes announced in the March 2011 Budget may make it easier to find. The rate of income tax relief for investment under the enterprise investment schemes (EIS) increased from 20% to 30% from 6 April 2011. Further changes to the EIS rules next year will mean more companies will qualify.

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