The opportunity to manage your tax liability is one of the most important motivators for a contractor choosing to operate via limited company. However, particularly if you are moving from a situation where all issues of taxation were handled for you by your employer's payroll department, it can also be one of the most intimidating of your new responsibilities.
In most cases, of course, a contractor will not have to work out their own tax liability - this is one of the main reasons why you hire an accountant. However, as with all aspects of your business, the better you understand the rules and regulations, the better able you will be to manage your limited company to your, rather than the taxman's, advantage.
Tax law and administration has an at least partially deserved reputation for complexity, but this largely arises from the almost limitless variety of situations that it has to cover. A contractor selling their services through a limited company should find that their tax liability falls into three areas: corporation tax; tax payable on dividends; and PAYE/National Insurance.
A word of warning. It is only possible to take advantage of the preferential tax regulations that apply to limited companies if you can show that your contracts do not fall within the IR35 'intermediaries legislation'. It is worth taking expert advice to ensure that you can demonstrate self employment and are not an employee masquerading as an independent contractor.
The most important tax liability that applies to limited companies is Corporation Tax. This is a levy on your company's profits, that is to say the money that is left over once your business expenses, including your salary, have been deducted from your turnover. Trading profits, profits from investments and capital gains are all subject to Corporation Tax.
The first step in complying with Corporation Tax regulations is to register your company with HMRC. This must be completed within three months of commencing trading. The easiest way to do this is by completing the snappily-named HMRC form CT41G; you should be sent this by HMRC once they have been notified (by Companies House) that your company exists, but it is advisable not to wait but rather to complete the registration at the earliest opportunity.
Corporation Tax is calculated and paid annually based on what is called your 'Corporation Tax accounting period', which is usually the same as your company's financial year. HMRC will notify you of your Corporation Tax accounting period, along with the relevant submission and settlement deadlines, once they have received form CT41G. An important point to remember is that unlike most taxes, the deadline to pay your Corporation Tax bill is earlier than the deadline for submission of the associated Company Tax Return - assuming your turnover is less than £1,500,000, you have twelve months from the end of your accounting period to file your return, but only nine months to pay any tax due.
HMRC gives an overview and detailed guidance for Corporation Tax on their website here. The current rates of Corporation Tax can be found here.
Tax On Dividends
Most contractors operating a limited company will pay themselves a mixture of a salary and dividends, as this allows them to make considerable tax savings. Dividends are payments made to the shareholders of a company - which, in the case of your limited company, generally means you alone.
Dividends themselves are not tax-free; they qualify as income and must be declared on your self-assessment. However, they are taxed at a lower rate than standard income, and are free of National Insurance. In addition, because dividends are paid out of income that has already been taxed, they include a tax credit component which ensures that the same income is not taxed twice. Current tax rates for dividend income can be found on the HMRC site here.
Dividends are paid out of your company's post-tax profits - that is to say, the money left over once you have paid your Corporation Tax. You pay dividends by declaring them, by documenting the declaration in the form of company board meeting minutes, and by issuing a dividend voucher to each shareholder.
Once declared, the dividend itself can be paid whenever you want. It is crucial, however, that you do NOT pay out more in dividends than you can afford after allowing for tax, even if you expect to make up the additional funds before your Corporation Tax falls due, as to do so would break company law.
HMRC gives more details on the payment and taxation of dividends here.
PAYE and National Insurance
Income tax and National Insurance contributions, or NICs, are payable on the salary that you pay yourself out of your limited company's turnover. It is common for contractors who are not caught by IR35 to pay themselves a very low salary (e.g. minimum wage) to keep income tax and NICs to a minimum, taking the remainder of their income as dividends. Because you are automatically your company's director, you will need to contact HMRC to set up a PAYE scheme to pay yourself.
Income tax is calculated on your gross salary, taking into account the various thresholds and allowances in force. NICs come in several flavours: Class 1, or Employer's Contributions, calculated from gross salary; Class 2, which are a flat weekly rate; and Class 4 which are also calculated on your gross salary. Latest information on income tax and National Insurance rates and allowances can be found on the HMRC website. Dedicated accounting software can be used to work out the tax and NICs due based on your salary. Tax and NICs due must be paid either monthly or, if the amounts are low, quarterly.
Of course, there is more to tax than just these three areas - for one thing, this article does not cover VAT, which is a subject in itself. Expert advice is strongly recommended - discuss taxation with your accountant and get their view on the best way to arrange and present the accounts for your limited company's specific situation. Remember - getting the balance right between the various types of income, and therefore the various types of tax, is central to maintaining your company's profitability and achieving that goal of tax efficiency that sent you down the limited company route in the first place.
Doug Brett-Matthewson, www.contractoruk.com