Contractors often form a limited company to do business with clients. A limited company can reduce the taxes you pay if you are not an employee of the client under the terms of IR35. The taxes you pay as a limited company include corporate taxes and income tax.
The finances of a limited company are separate from those of the shareholders, who are not responsible for the debts that the company incurs. All limited companies have the following requirements:
- Register with Companies House
- File annual accounts with Companies House
- File annual statement on taxable income with Her Majesty’s Revenue and Customs
- File annual corporation tax return with HMRC.
IR35 is piece of legislation that took effect in April 2000. It generally means that HMRC can tax some contractors as employees, which can reduce your take home pay by up to 25 percent. The classification of a contractor under IR35 is complex, but must consider the following factors:
- Background of the position
- Previous rulings on the position
- Validity of the contract
- Client’s control over the contractor
- Contractor’s right to supply a substitute
- Contractor’s right to work for other clients
- Guarantee of work
- Requirement to use the client’s equipment
- Contractor’s integration into the client’s organization
- Intention of the client and contractor
The default corporation tax in the 2012 budget is 24 percent, although many companies pay less than this. Small companies pay a 20 percent tax rate, for example. Corporation taxes are due nine months after the end of the tax year.
The best approach for minimizing your taxes if your contract is exempt from IR35 is generally to combine high dividends with a low salary. This approach means you will only pay corporation tax on your company’s net profit, since dividends are paid from the company’s profits. Your salary will generally be equal to your company’s income if your contract is not exempt from IR35. This means your company will show very little profit and will therefore pay little to no taxes.
You will pay personal income tax on your salary, which will be deducted as a pay as you earn tax. This tax is deducted from your income on a monthly basis. Your income tax should be very small if your contract is exempt from IR35. Your entire income will generally be subject to PAYE if your contract is not exempt from IR35.
Corporate dividends have tax credits on contracts that are exempt from IR35. This means you will not pay taxes if your taxable income is less than the threshold for the higher tax rate. Any income above this threshold is subject to taxation at the rate determined by the difference between the high rate and basic rate. This difference is currently 18 percent.
A limited company requires additional paperwork to create and operate. It will typically benefit you only when you are working as a contractor under the terms of IR35.