A question we were asked recently was:
I’ve been offered a contract of £120k a year. It’s my choice whether I go onto payroll for a 12-month fixed term contract or if I go self-employed or set up a limited company and bill the client. If I set up my own business, this will be my main client in the short term, but I would have the option to take on more clients and boost my income later down the line. Which is the most tax-efficient.
Our response:
Making the leap from employment to self-employment is a significant decision for any professional, especially in the marketing field. Each route—being an employee, a sole trader, or operating through a limited company—has its unique set of advantages, disadvantages, and tax implications. This guide aims to shed light on these aspects, helping marketing professionals make informed decisions about their career paths.
Employee vs. Sole Trader vs. Limited Company: An Overview
Employee: As an employee, you work under a contract of employment, and your employer deducts taxes and National Insurance Contributions (NICs) through the PAYE system. You have employment rights and benefits such as sick pay, holiday pay, and potentially, pension contributions.
Sole Trader: Sole traders run their business as individuals and are self-employed. You keep all profits (i.e. all sales less qualifying business expenses to help you achieve those sales) after tax but are personally liable for any losses. Tax and NICs are paid through Self Assessment. You can personally contribute to a personal pension scheme. There will be costs associated with running your business and these will be deducted from your profits. On the upside, you will pay less tax; on the downside – that will eat into your take-home pay so be mindful and frugal before you spend!
Limited Company: A limited company is a separate legal entity from its owners (shareholders) and directors. Profits are subject to Corporation Tax. Directors may draw a salary (subject to PAYE) and dividends. Your company can contribute to your personal pension scheme. Again, there will be costs associated with running your business and these will be deducted from your profits. On the upside, you will pay less tax; on the downside – that will eat into your profits after tax and, therefore, the profits available for you to take as dividends – so be mindful and frugal before you spend!
VAT
Whether you are self employed or running a limited company – your turnover will be over the VAT threshold which as at the time of writing this blog would be £85,000 per year (£90,000 from the 1st April 2024) so you will need to register for VAT around month 8-9 of your self-employed journey.
Key Considerations Before Going Self-Employed
- Liability: Sole traders have unlimited liability, meaning personal assets are at risk if the business fails. Limited companies offer limited liability protection.
- Control and Privacy: Sole traders have full control but less privacy, as accounts are not publicly filed. Limited companies file accounts with Companies House, but offer more control over how you pay yourself.
- Tax Efficiency: Understanding the tax implications is crucial. Limited companies can be more tax-efficient, but come with more complex reporting requirements.
Advantages and Disadvantages
| Aspect | Employee | Sole Trader | Limited Company |
|---|---|---|---|
| Liability | N/A | Unlimited, personal assets at risk | Limited, personal assets generally safe |
| Tax Efficiency | Taxed at source, less control | Pay tax on profits via Self Assessment | More options for tax planning |
| Flexibility | Less control over hours or work | High flexibility in operations | Flexible, but with more regulations |
| Privacy | N/A | High, no requirement to publish accounts | Low, accounts and details are public |
Tax Implications and Take-Home Pay Comparison
Assuming an annual income of £120,000, let’s compare the tax implications and take-home pay for each option. I’ve ignored pensions for the purpose this comparison.
Assumptions:
- For the employee and sole trader, income tax and NICs are calculated for the 2023/24 tax year.
- For the limited company, it’s assumed the company will register as an employer and run a small director payroll up to the NIC threshold and take the rest as dividends.
- For the sole trader and limited company, let’s assume £2,500 per year of very minimal business expenses: telephone, work-from-home allowance, accountant’s fees, travel, subsistence, software, etc. It’s important before you consider going self employed to properly map out your potential costs. These are very lean costs on the assumption that this is a contractor
- Corporation Tax is assumed at a marginal rate. Profits of £50,000 and under are taxed at 19%. Profits of £250k and over are taxed at 25%. Profits between £50k and £250k are taxed on a marginal relief basis, meaning that the tax rate gradually increases from 19% to 15% as profits increase.
- Personal Allowance is assumed to be £12,570 (subject to reduction over £100,000 income).
- > Payroll of £120k – Adjusted net income is over the personal allowance threshold of £100,000. The allowance has been reduced to £2,570 (from the default £12,570).
- > Sole Trader earnings of £117.5k – Adjusted net income is over the personal allowance threshold of £100,000. The allowance has been reduced to £3,820 (from the default £12,570).
| Description | Employee (£) | Sole Trader (£) | Limited Company (£) |
|---|---|---|---|
| Sales | 120,000 | 120,000 | |
| Less Directors Salary | (12,570) | ||
| Less basic business expenses | (2,500) | (2,500) | |
| Taxable Income | 120,000 | 117,500 | 104,930 |
| Taxes Paid | |||
| Income Tax | £39,432 | 37,932 | – |
| NICs | 5,165 | 4,920 | – |
| Corporation Tax at 20% marginal rate | – | – | 21,086 |
| Net Income/Profit after Tax | 75,403 | 74,648 | 83,844 |
| Dividends | – | – | 86,844 |
| Dividend Tax | – | – | 19,787 |
| Dividends After Tax | 67,057 | ||
| Take-Home Pay | 75,403 | 74,648 | 12,570 salary plus
67,057 dividends £79,627 total |
| Effective tax rate: How much of your earnings do you pay in tax? | 37.1% | 35.7% | 34.1% |
Note: These figures are illustrative and simplified for comparison purposes. Actual tax liabilities may vary based on specific circumstances and tax legislation changes.
Wait! What about IR25?
Last but not least – we must add a caveat about the risks and implications of IR35.
IR35, also known as the off-payroll working rules, is legislation designed to combat tax avoidance by workers supplying their services to clients via an intermediary, such as a limited company, who would otherwise be an employee if the intermediary was not used. This legislation aims to ensure that workers, who would have been employed if they were providing their services directly, pay broadly the same tax and National Insurance contributions as employees.
For contractors considering operating through a limited company, the IR35 rules are particularly relevant. The key risk associated with IR35 is the potential for HMRC to challenge the employment status of a contractor. If HMRC deems that the working arrangement resembles employment rather than genuine self-employment, the contractor could be considered ‘inside IR35’, leading to increased tax and NIC liabilities as if they were an employee.
Factors to Consider:
- Control: How much control does the client have over what, how, when, and where the worker completes the work?
- Substitution: Can the worker send someone else to do the work in their place?
- Mutuality of Obligation: Is the client obliged to offer work, and does the worker have to accept it?
Being inside IR35 can significantly reduce a contractor’s net income, as it entails paying income tax and NICs similarly to an employee, without the benefits of employment, such as holiday pay or pensions.
Strategies to Mitigate IR35 Risk:
- Contract Review: Ensure contracts with clients clearly reflect self-employment terms, focusing on control, substitution, and mutuality of obligation.
- Working Practices: Actual working practices should align with the contract and demonstrate self-employment.
- Professional Advice: Consulting with an IR35 specialist or tax advisor can provide tailored advice and strategies for staying outside IR35.
If you are in any doubt – you can use HMRC’s Employment Status for Tax Tool (CEST) to find out if HMRC would consider you an employee or a worker for a particular engagements.
While operating as a limited company can offer tax efficiency and limited liability, the risk of falling within IR35 highlights the importance of careful planning and compliance. Marketing professionals should ensure their working arrangements genuinely reflect self-employment to avoid potential challenges from HMRC. By understanding IR35 and taking proactive steps to mitigate its risks, contractors can better position themselves to reap the benefits of operating through a limited company while minimizing their tax liabilities and legal risks.
Conclusion
Choosing between being an employee, a sole trader, or setting up a limited company as a marketing professional depends on personal circumstances, career goals, and tax efficiency considerations. While employment offers stability and fewer tax worries, self-employment as a sole trader or through a limited company can provide greater flexibility and potential tax savings. It’s crucial to weigh the pros and cons and possibly consult with a financial advisor to make the best decision for your situation.
Remember, the transition from employment to self-employment is a significant step that requires careful planning and consideration of the legal and tax implications associated with each business structure.
