This is a question that gets asked a lot and usually at parties! So I have answered this below.
There are two reasons why someone will look at becoming a Ltd Company (otherwise known as incorporating).
1. Liability for the individual and
2. Tax.
1. Liability
When you set up a Limited Company you are creating a ‘legal entity’ which is responsible for its own actions. So now you have two legal entities, you and the Company. If the Company runs into cashflow troubles or has a customer that is unhappy with a product/service and is suing for compensation, the Company alone is liable for this and not you – your personal assets are protected. However, it is worth noting at this point that any Director of a Ltd Co. has certain obligations (fiduciary duties) to ensure the Company operates correctly and legally. If it is felt that the Director did not do this (s)he can also be sued.
Whether you do incorporate or stay as a sole trader it is ALWAYS advisable to have indemnity insurance for such occasions.
2. Tax
This is usually the driving force to incorporation and is easier explained with an example.
JD owns a business with taxable profits of £300,000, he takes drawings from the business of £92,000 (self-employed); and salary of £12,000 with dividends of £80,000 (Ltd Co employed)
Self-employed
Income £300,00
Personal Allowance -£12,570
Taxable income £287,430
Tax calculation
Basic rate (to £37,700) at 20% £7,540
Higher rate (£37,701 to £150,000) at 40% £44,920
Additional rate (£150,001 to £300,000) at 45% £67,500
Total Tax payable £119,960
Regardless of the amount of drawings JD takes, he will be taxed on the total profits!
Ltd Company employed
Income £12,000
Dividend Income £80,000
Income subject to tax £92,000
Personal Allowance -£12,570
Taxable Income £79,430
Dividend Allowance -£2,000
£77,430 (all Dividend income so taxed at dividend rates)
Tax Calculation
Basic Rate (to £37,700) at 7.5% £2,828
Higher Rate (from £37,701 to £77,430) at 32.5% £12,912
Total Tax payable £15,740
In addition the Company will pay corporation tax of;
£300,000 at 19% £57,000
Total tax payable by both legal entities £72,740
This leads to a significant tax saving of (£119,960 - £72,740) £47,220