Limited company contractors would most likely see an increase in the tax paid on their dividend payments should there be a merger of income tax and National Insurance Contributions (NICs). At the same time, it is also likely that IR35 would become irrelevant. The issue is being debated in contracting circles following leaked plans to end NICs by a future Conservative government.
“There is a huge difference in the tax burden of the employed, self-employed and partnerships, and those running limited companies,” says James Abbott, founder and head of tax at contractor accountant Abbott Moore. “The disparity is largely down to the separate treatment of income tax and NICs.”
“Trying to merge the two without penalising one element of the business community or individual investors is a huge challenge.” He points out that it is those using limited companies who currently benefit the most, and so they who would most likely have to fund the resulting tax gap through increased taxation on their earnings.
“But there are benefits to the proposed change, not least of which is the resulting tax simplification,” he says. “And if limited company contractors were paying similar levels of tax to employees, umbrella company contractors, self-employed sole-traders and partners, then IR35 – and the expense and hassle that comes with it – would become irrelevant.”
The limited company phenomenon is relatively recent
Abbott continues: “If you examine the tax disparity between employed workers and business people, there is some justification for the tax gap, as it recognises the risk taken by business people. But if you look at the average plumber setting up as a sole trader versus one incorporating a limited company, they can pay very different amounts of tax, and there is little justification for the disparity.”
There is a huge difference in the tax burden of the employed, self-employed and partnerships, and those running limited companies
James Abbott, Abbott Moore
Abbott notes that if you look back through history, running a limited company used to be nowhere near as attractive, or as cost effective, as it is now: “Most small businesses started as sole traders and, as they grew, remained sole traderships or evolved into partnerships. There was no need for a dramatic change in business vehicle, largely because the relative profits they made stayed the same as they grew.”
But as the small company’s corporation tax rate has fallen, national insurance costs increasing alongside lower costs of incorporation and limited company compliance, this trading option has unsurprisingly become more prevalent, And the tax gap has widened.
Why do business people choose different trading vehicles?
According to Abbott, the motivation for incorporation has not always been tax efficiency: “Business owners may wish to separate their personal and business assets, carve out a standalone brand or groom their business for an eventual sale. And, of course, many contracting clients and agencies won’t hire anyone not using a limited company for employment law reasons.
“The limited liability partnership (LLP) was created to address some of these issues. But still the tax disparity remains. The business owner of a tax-efficient limited company with profits of £80,000 could expect to net £59,000 after tax. A member of an LLP with an £80,000 share of profits would only take home £54,000. This difference is accounted for by the NICs that an LLP pays on profits that a limited company does not pay on dividends.
Ironically, if income tax and NICs were merged, then it may become more tax efficient for some contractors to use LLPs because of the favourable tax treatment of items such as motor vehicles and their associated costs.
Many limited company contractors may also turn to professional employment solutions, such as umbrella companies, as they could lose any tax advantages through the limited company option but still face the compliance and running costs.
Simplification is rarely fair
Abbott believes that whatever the solution, a merged income tax and NIC regime will most likely impact negatively on limited company contractors: “Ultimately, dividends are supposed to be an investment return and not an earned return. You could imagine creating yet another trading entity that could resolve the conundrum, but that would add further complexity, and would not match the current government’s simplification agenda.
“Reducing NICs for the self-employed, which currently adds an additional 9% in tax that limited company contractors don’t pay, might be another option. But this would again lead to a tax gap that would have to be filled from somewhere.
“Alternatively, HMRC could introduce a simple rule that close companies owned by a small number of shareholders attracts a higher dividend tax. This would eliminate the existing tax advantages for one- or two-person contracting companies but not penalise those who own company shares as investments.”
IR35 would become irrelevant
Irrespective of what mechanism might actually be used to level the playing field, if income tax and NI were merged, the tax advantages of incorporation would largely disappear.
“Removing the tax advantages of incorporation for small, one- or two-person contracting companies would also completely remove the need for IR35,” says Abbott. “However, that may be scant comfort for limited company contractors if they are suddenly required to pay additional tax on their dividends or other remuneration.”
Abbott concludes: “The simplification agenda may superficially sound positive for contractors, but in the case of merging income tax and NICs, it is unlikely to end benefitting contractors.”