In our example we consider an IT-contractor at the start of his career and facing the question to start his career as a limited company or a sole trader. If an IT-contractor is not at the start of their career, they might have already figured out that they should be trading through a limited company.
So, lets take an example with profits of £24,000 per annum.
IT-Contractor with limited company
Salary for you (which is an expense for the company): £8,425 (this is the pay till where you do not have to pay any employee or employer NI, but still this pay is above the Lower Earnings Limit for National Insurance required in order to qualify for state benefits). This salary changes every year to year depending on the taxes/tax rules that are in force in the year.
Corporation Tax on remaining profits after deducting salary: £2,959.25
Tax free dividends for you : £3,426 (Again, this can change year to year. Currently you get £2000 dividends as tax-free and rest taxed at 7.5% if you are a basic-rate tax payer)
Personal tax on the rest of the dividends if you take the money out: £689.23
Total taxes paid £3648.48
IT-Contractor as sole trader
Sole trader has to pay income taxes and Class 4 NIC and cannot take out salary or dividends like a limited company. So, for an operating profit of £24,000, a IT-contractor operating as a sole trader will pay £3623.80 in taxes.
Total taxes paid £3623.80
If looks like a sole trader is better off than an IT-contractor limited company by £24.68. So, in this case it is better for a IT-contractor to take the sole trading route than going for a limited company as the profits are low and they do not have to deal with the overhead of doing all the needed IT-contractor limited company accounting. However as the profits increase, you might have to consider which option is tax effective and shift accordingly to take advantage of the current HMRC taxes. Also, as the contractor advances in career, many big software companies require that their contractors operate through limited companies rather than sole trader.
In our example, we have only considered which option to consider to save taxes. However, their might be many other reasons where even though a sole trading option saves taxes, you might want to take a limited company route. That's for a different article.
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