If you run a modestly profitable unincorporated enterprise, incorporating as a limited company has traditionally been a nifty way to stash away more cash. Many small firms reduced owner-manager income tax and national insurance bills by taking a low salary and retrieving remaining profits as lightly taxed dividends. But with the recent cracking down on dividend tax relief, is incorporation still worthwhile or should sole traders think twice?

How Dividend Taxation Changed

Until April 2016, all company dividends included a 10% notional tax credit, reflecting that dividend pay-outs are not tax-deductible business expenses for corporation tax. This tax credit system meant basic-rate taxpayers owed no extra personal tax on dividends, while higher and additional-rate taxpayers still enjoyed lower dividend rates than normal income.

Yet this favourable system was too good to last. 2016, the dividend tax credit vanished, replaced by a £5,000 tax-free dividend allowance. More painfully, dividend tax rates increased for higher and additional rate taxpayers. The allowance was then repeatedly reduced and sat at just £1,000 for 2023/24. Meanwhile, an extra 1.25% health and social care levy has lifted dividend tax rates.

Measly Allowance, Meatier Rates

That measly £1,000 allowance is less generous than it seems, too. It is not technically an allowance at all but a nil-rate band. So, although the first £1,000 of dividends are tax-free, they still reduce other allowances and may trigger extra charges. Dividends above the nil rate band are taxed at 8.75% for basic ratepayers or 33.75% for higher-rate taxpayers.

The combined effect of base corporation tax, increased dividend tax rates after 2016 and, more recently, the health and social care levy means total income tax can now approach 50% of company profits retrieved as dividends. As profits rise, the savings through incorporation for owner-managers are much less appealing.

Silver Linings for Lower Profits?

Yet 2023 has brought a sliver of sunshine for companies with profits up to £50,000. The small profits corporation tax rate remains 19%, while marginal relief reduces the effective tax rate to 26.5% for profits between £50,000 and £250,000. For those with lower profits, incorporation can still substantially reduce income tax and national insurance versus operating as a sole trader.

Assuming sensible salaries that minimise national insurance are drawn, a company making £40,000 profit might save an owner-manager around £7,500 in income tax and class 4 NICs annually. Even at the £100,000 profit mark, the savings could approach £15,000. So incorporation can still unlock considerable tax savings, especially if profits remain under £50,000 indefinitely.

Future Upheaval

Of course, whether the current tax regime lasts is far from assured, given the economic climate. The government previously proposed taxing small company profits as personal income, although this appears shelved for now. But with ballooning national debt after COVID-19, everything is guaranteed to be stable. Stealthy tax grabs on dividends, salaries, or company profits remain distinct possibilities.

To Incorporate or Not Incorporate?

For moderately profitable unincorporated enterprises, incorporating as a company can still provide substantial income tax and national insurance savings versus remaining a sole trader. However, the advantages have diminished due to repeated dividend tax disincentives since 2016. Before taking the limited company leap, micro-business owners should consider their likely future profit levels.

If you can reliably forecast profits below £50,000 indefinitely, becoming a company director makes sound financial sense thanks to the lower small profits corporation tax rate. Just keep salaries modest and stash surplus profits as lightly taxed dividends. At the £100k profit mark, incorporation still saves around £15k tax versus sole trading. But as income edges towards £200k, the advantage shrivels away.

Nobody has a crystal ball to predict future earnings or tax upheaval. But by modelling different scenarios with your accountant, unincorporated enterprises can determine if incorporation still promises to return more bang for business bucks despite the recent dividend tax squeeze. It’s always recommended to get some advice from tax consultant, who should plan with upcoming changes in the future.