Understanding Business Accounting For Dummies, 2nd Edition (87 page)

Choosing the Right Legal Structure for Tax Purposes

In deciding which type of ownership structure is best for securing capital and managing their business, owners should also consider the tax factor.

Taxable-entity companies:
These companies pay tax on their annual taxable profit amounts. Their shareholders pay income tax on cash dividends that the business distributes to them from profit, making the company and its owners subject to double taxation. The owners (shareholders) of a company include in their individual income tax returns the cash distributions from profit paid to them by the business.

In the following examples, we assume that the business uses the same accounting methods in preparing its profit and loss account that it uses for determining its taxable income - a realistic assumption.

Companies

Whether trading as a limited company or public limited company, the tax rules are much the same. True, a small company, defined as one making less than a certain amount of profit, currently £300,000 a year, may end up paying less tax than its bigger brothers, but the basic deal is the same.

Suppose you have a company with the following abbreviated profit and loss account (see Chapter 5 for details on profit and loss accounts):

Sales revenue £26,000,000

Expenses, except Corporation Tax (
23,800,000
)

Earnings before tax £2,200,000

Corporation Tax
(748,000
)

Net income £1,452,000

The £748,000 corporation tax is determined by the fact that this business's £2.2 million taxable income puts it in the 34 per cent tax bracket (corporate taxable income rates have moved around the 30 per cent rate in recent years, but have been much higher and may yet be again. The actual rate makes no difference to the argument developed in this example):

£2,200,000 taxable income × 34% tax rate = £748,000 tax


That's a big chunk of the business's hard-earned profit. You must also consider the so-called
double taxation
of corporate profit - a most unpleasant topic if you're a shareholder in a company. Not only does the company have to pay £748,000 corporation tax on its profit (as we just calculated), but when the business distributes some of its after-tax profit to its shareholders as their just rewards for investing capital in the business, the shareholders include these cash dividends as income in their individual income tax returns and pay a second tax.

For a rather dramatic example, suppose that this business distributed its entire after-tax net income as cash dividends to its shareholders. (Even though most businesses don't pay 100 per cent cash dividends from their net incomes.) Its shareholders must include the cash dividends in their individual income tax returns. How much each individual pays in taxes depends on his or her total taxable income for the year, but let us make an arbitrary (but reasonable) assumption that the shareholders are, on average, in the marginal 31 per cent tax bracket. In this example, the shareholders would combine to pay £450,120 total individual income tax on their dividend incomes:

£1,452,000 dividends × 31% income tax rate = £450,120 total individual income tax paid by shareholders


You can calculate the total tax paid by both the company and its shareholders as follows:

£748,000 paid by the company on its £2,200,000 taxable income

£450,120
paid by its shareholders on £1,452,000 in cash dividends

£1,198,120 total tax paid by both the company and its shareholders

Compare this to the company's £2,200,000 of taxable income. Out of the £2,200,000 pre-tax profit that the business earned, £1,198,120 is quite a bit of total tax to pay - more than half. On the other hand, if the company had retained all of its after-tax profit and paid no cash dividends, then at least for now the individual shareholders would not have to pay the second tax. Distributing no cash dividends may not go down well with all the shareholders, however. Most companies - but by no means all - pay part of their after-tax net income as cash dividends to their shareholders.

The distribution of profit to the shareholders in the dividend payment gives the appearance of taxing the same profit twice, but through a process of
tax credits
this double taxation doesn't generally occur. When a shareholder gets a dividend from a company, it comes with a tax credit attached. This means that any shareholder on the basic rate of tax won't have to pay any further tax. Higher rate taxpayers, however, have a further amount of tax to pay. So every shareholder takes a tax cash hit when dividends are distributed, but only higher rate taxpayers actually end up losing out.

Partnerships, limited liability partnerships, and sole proprietorships

Sole traders (self-employed) have all their income from every source brought together and taxed as one entity. Partnerships are treated as a collection of sole traders for tax purposes, and each partner's share of that collective liability has to be worked out. Under the self-assessment tax system in the UK, the basis of a period of a year of assessment is the accounting year ending within that tax year. There are special rules that apply for the first year and the last year of trading that should ensure tax is charged fairly.

If your turnover is low, currently in the UK less than £15,000 per year, you can put in a three-line account on your standard tax return: Sales, expenses, and profit. No need for expensive accountancy advice here. If it is over whatever the current low figure is, then you have to summarise your accounts to show turnover, gross profit, and expenses by main heading.

You will have a personal allowance: the current threshold below which you don't pay tax. That amount is deducted from the profit figure. All these rates and amounts are constantly changing, but the broad principles remain.

Partners don't actually get paid salaries, although partners may take monthly draws (withdrawals from the partnership) that may look like salaries. These may be listed as
drawings
. Partners are not employees but rather owners whose compensation consists of sharing in the profit of the partnership. A partner's share of profit may be disproportionately large as a substitute for a salary, if that partner puts in more hours at the business or otherwise makes a disproportionate contribution. But the amount paid out is a withdrawal of profit by the partner and not a true salary.

Deciding which legal structure is best

The most important rule is never to let the ‘tax tail wag the business dog'. Tax is just one aspect of business life. If you want to keep your business's finances private, then the public filing of accounts required of companies will not be for you. On the other hand, if you feel that you want to protect your private assets from creditors if things go wrong, then being a sole trader or partner is probably not the best route to take.

Company profits and losses are locked into the company, so if you have several lines of business using different trading entities, you cannot easily settle losses in one area against profits in another. But as sole traders are treated as one entity for all their sources of income, there is more scope for netting off gains and losses. Some points to bear in mind here are:

If your profits are likely to be small, say below £60,000, for some time, then from a purely tax point of view you may pay less tax as a sole trader. This is because as an individual you get a tax-free allowance. Your first few thousand pounds of income are not taxable. This amount varies with personal circumstances, if you are married or single, for example, and can be changed in the budget each year.

If you expect to be making higher rates of profit (above £60,000) and want to reinvest a large portion of those profits back into your business, then you could be better off forming a company. That is because companies don't start paying higher rates of tax until their profits are above £300,000. Even then they don't pay tax at 40 per cent. A sole trader would be taxed at the 40 per cent rate by the time their profits had reached about £35,000, taking allowances into account. So a company making £300,000 taxable profits could have around £50,000-£60,000 more to reinvest in financing future growth than would a sole trader in the same line of work.