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Limited Company Tax Guide for Contractors

So you’ve decided to operate your business through your own limited company because everything you've read and any advice you've taken, has told you that (subject to your contracts falling outside of IR35) the limited company option was the most tax efficient way to operate. Well it is, so rest assured that you’ve made the right decision, but what exactly does it all mean? What taxes will you pay as a contractor operating through your own limited company?

The taxes imposed by HMRC fall into two categories, these are;-

  • Personal tax
  • Company tax
Personal tax

As a limited company director, tax on your personal income is payable in three ways;-

  • Income tax on your Salary
  • Income tax on your Dividends
  • National insurance
Income Tax on Salary

As a permanent employee earning more than £11,000 per annum you are liable for income tax on earnings over £11,000 via the PAYE (pay as you earn) system. With this system, your employer deals directly with the Inland Revenue, deducting any tax that you owe from your gross salary prior to paying you; therefore what you receive is your net pay, otherwise known as your take home pay (your earnings minus income tax and national insurance). More about national insurance below.

As a Director of a limited company, your tax liability is no longer confined to the PAYE system; you are also obliged to file a Self-Assessment Tax Return annually. Income tax rates for limited company directors are the same as they are for employees and the same income thresholds apply. However, you can legitimately pay yourself a small salary, equating to no more than the national insurance threshold, (currently £8,060 pa) and take the rest in dividends, thus avoiding income tax or national insurance on your salary.

Income Tax on Dividends

As a company shareholder, you will also pay income tax on the dividends that you pay yourself. However, unlike salaried income, dividend income is not subject to national insurance (NI), providing a significant tax benefit to limited company owners.

Dividends are paid out of company profits after corporation tax (more about Corporation Tax below).

The table below shows the tax rates applicable to different levels of annual dividend income for the 2016/2017 tax year.

Dividend income taxation bands

% Tax rate applied

Dividend income up to £5,000

0%

Dividend income between £5,001 and £32,000

7.5%

Dividend income between £32,001 and £150,000

32.5%

Dividend income over £150,000

38.1%

 

National Insurance

As an individual, you are liable for Employees’ NICs on the salary you draw from your company but as mentioned above, most contractors pay themselves a low salary, often below the NIC threshold, to minimise their exposure to both income tax and National Insurance Contributions. This is perfectly legitimate and is one of the reasons why operating as a limited company is the most tax efficient option for most contractors.

Companies are also liable to pay Employers’ National Insurance Contributions (NICs) on salaries paid to their staff but again, most contractors set their salary below the threshold for NI and therefore no NI is due.

Company Tax

Company tax also falls into two categories. These are:

  1. Corporation tax
  2. Value Added Tax
Corporation Tax

All companies now pay Corporation Tax (CT) on their annual profits at 20%.

Your accountant will register your company for Corporation Tax with HMRC, once your company is registered with Companies House (the registrar of companies in the UK), and will prepare your Annual Accounts each year. They will then submit these to HMRC together with a Company Tax Return showing in detail how much of the net profit shown in the Annual Accounts translates into taxable profit for the year.

For example, some expenses often seen in company accounts are not allowed for tax purposes, so they must be added back to the profit in the Corporation Tax Computation.

These expenses include:

  • Business entertainment
  • Depreciation on assets

There are also some tax allowances and reliefs that do not feature in a company’s accounts and need to be deducted from the profit prior to tax being charged.

These include:

  • Capital allowances
  • Group Relief

The accounting period for limited companies doesn't coincide with the tax year. It is, instead, your company's own accounting period, beginning and ending with the dates of your financial accounts. As a limited company, the deadlines for filing your company tax return and paying what you owe are as follows;-

  1. You must pay Corporation Tax within nine months and 1 day of the end of your company's accounting period
  2. You must file your Corporation Tax Return within 12 months of the end of your company's accounting period.
  3. You must file your accounts with Companies House within 9 months of the end of your company's accounting period.
Value Added Tax

The vast majority of contractor companies are also registered for Value Added Tax (VAT). If you are VAT registered then VAT is applied to all services you provide to your contracting clients, and you can reclaim VAT on purchases you make via your company (subject to the conditions of any special VAT scheme you join). The standard rate for VAT (which you charge to your client) is 20%.

If your annual turnover is £83,000 or more, you must register for VAT. However, in many instances it can be beneficial to register even if you are not obliged to do so as you could benefit financially.

The Flat Rate VAT Scheme

The flat rate VAT scheme is an incentive provided by the Government to small businesses to help simplify taxes. You charge VAT on your invoices at the prevailing rate but pay it back to HM Revenue and Customs at a lower rate, thus allowing you to benefit financially from the difference in rates. Rates differ depending on your profession/trade but for IT contractors the rate is 13.5% in your first year (1% discount applied for first year of trading) and 14.5% in subsequent years.

VAT Flat Rate Scheme Changes – 1st April 2017

From 1st April 2017, the government introduced a new definition of a 'limited cost trader" (see definition below) to the flat-rate vat scheme. The result is that affected contractors must use a new percentage of 16.5% The introduction of this new rate means the flat rate scheme is no longer suitable for the vast majority of Contractors who will now generally be better suited to the standard rate VAT scheme, where they can at least offset some of the VAT paid on purchases against what they have to pay HMRC.

The definition of the newly introduced category of a “limited cost trader” is one whose VAT “inclusive” expenditure on “goods” is either; less than 2% of their VAT inclusive turnover, or less than £1,000 in total, per year.

If you are unsure which VAT scheme will be most suitable for you, please contact our team on 0800 954 2101 who will be happy to advise you.

Once your company is VAT registered, you will need to submit an online VAT return to HMRC each quarter, together with an electronic payment, or elect to pay via direct debit.

We hope this article has helped to simplify the complexities of limited company taxation. However, if you have any further queries or wish to discuss setting up your own limited company, please do not hesitate to call us. Or, to see how much you could earn, simply complete the enquiry form opposite and we'll provide you with an income illustration.

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Freestyle Accounting – Limited Company Contracting Made Easy!

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