Limited Company or Self-Employment

Do you finally want to start working for yourself and are wondering which business structure will be most beneficial for you? While there are many publications on this topic online, we will focus on calculations that will most reliably show what will be more profitable for you: self-employment or a Limited Company.

Self-employment (self-employment) - key features

A self-employed person cannot pay themselves a salary – they pay annual income tax (income tax) on all profits earned during the tax year. They also do not pay monthly National Insurance Contributions (NIC) – all tax liabilities are settled at the end of the tax year. If you want to avoid a large bill to pay in January, you can make monthly advance payments for income tax throughout the year, but these will be voluntary, not mandatory.

How a limited company (limited liability company) works

The profits of a limited company director can be paid out more flexibly – they can choose the form of payment. This can be in the form of a monthly salary under the PAYE system, but in that case, this salary cannot be lower than the National Minimum Wage (National Minimum Wage) and requires monthly National Insurance contributions.

Another option is dividend payments, which refers to profits earned by the company during the financial year. Dividend payments occur after the company's financial year-end and are exempt from NIC and taxed at a lower rate.

Self-employment vs. LTD – a comparison

Example.

In the 2022/23 tax year, Lilka's company, which offers luxury massages, earned £50,000. This is the amount remaining after deducting expenses, but before accounting for payments to the owner.

Assuming Lilka operates as self-employed, her taxes would be as follows:

1) 20% income tax on the profit remaining after deducting the tax-free allowance (in the 2022/23 tax year, this amount is £12,570):

£50,000 – £12,570 = £37,430

£37,430 x 20% = £7,486

2) Class 2 NI social insurance contribution of £3.15 per week:

£3.15 x 52 (number of weeks) = £163.80 ≈ £164

3) Class 4 National Insurance contribution of 9% on the amount remaining after deducting the exempt amount (£11,908):

£50,000 – £11,908 = £38,092

£38,092 x 9% = £3,428.28 ≈ £3,428

In total, tax payments will amount to £11,078, leaving the taxpayer with £38,992.

Assuming Lilka operates as Ltd company, it can pay itself a salary of any amount, including structuring payments to avoid National Insurance contributions – i.e., not exceeding £11,908 annually.

12 months x £992.33 = £11,907.96 ≈ £11,908

After deducting this amount, £38,092 of profit remains to be taxed with Corporation Tax (Corporation Tax – CT) at 19%:

£38,092 x 19% = £7,237.48 ≈ £7,237

Thus, £30,855 will remain in the company, which can be paid out as dividends. The first £2,000 of dividends in the 2022/23 tax year are taxed at 0%, and amounts above this are taxed at 8.75%. It's worth noting that Lilka still has £662 of income tax-free allowance remaining after monthly salary payments from the tax-free amount (£12,570 - £11,908 = £662). This amount can also be paid out as dividends, which would save Lilka an additional £50 in taxes (£662 x 8.75% = £57.925 ≈ £58). Therefore, the final calculations are as follows:

£28,855 x 8.75% = £2,524.8125 ≈ £2,548

£7,237+ £2,548 - £50 = £9,727

As a director of an Ltd company, Lilka will pay £9,727 to the tax authorities, leaving her with £40,273 after all taxes are paid.

As shown in the example above, an Ltd company is slightly more profitable in this case, however, whether it is more advantageous from an organizational perspective depends on personal preferences. The £1,281 (£40,273 - £38,992) that Lilka would save as an Ltd company might not be worth the additional costs and obligations associated with running a company, which is a more complex structure than self-employment. It's important to consider who would handle the company's accounting, the quality of that service, and its cost.

If your profits are moderate, the choice between self-employment and an Ltd company requires careful consideration. However, the benefits of operating as an Ltd company are undoubtedly greater when the business has higher turnover and profit.

Family businesses are a good fit for an Ltd company

The situation changes dramatically, if other people are involved in the business. Many small and medium-sized enterprises are de facto family businesses. Officially employing a spouse or another family member makes perfect sense, and is financially beneficial!

By using the above example, let's assume Lilka has a husband who helps her run the business by editing marketing materials and answering phone calls.

The husband can be employed as a director of the Ltd company and receive a salary similar to Lilka's, thus avoiding both tax and National Insurance contributions. If the husband is also a shareholder of the company, he can additionally receive a tax-free dividend of £2,000.

In such a situation, the couple will have significantly more money left after paying taxes: assuming the company earns £50,000 annually, Lilka and her husband will pay only £4,975 corporate tax. Dividend tax will amount to £1,613.

Therefore:
£4,975 + £1,613 - £100 = £6,488

After completing the calculations, the total tax payable is £6,488.

As a result, the couple will have a full £4,590 more in their pockets than if they were self-employed.

Despite the fact that running a limited company requires a lot more 'paperwork' and may involve higher accounting costs, it will still be more beneficial than self-employment, especially since there are other additional options for legally reducing taxes for Ltd companies.

It's also worth remembering that the progressive digitalization of the UK tax system greatly simplifies accounting, as using software like XERO, for example, enables real-time access to financial data, minimizing the need to sift through papers monthly. We have created a Xero Course on our website in the form of video episodes. It is still available for free to our readers via this link.

In summary: the higher the company's income, the greater the savings achieved by operating as a Limited Company.

Before making a decision, it's wise to plan everything out and consult with an advisor or tax consultant.

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Our example calculations will not apply to tax rates in Scotland due to different tax thresholds.
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