Calculating the tax benefits of incorporation

Produced by Tolley
Calculating the tax benefits of incorporation

The following Owner-Managed Businesses guidance note Produced by Tolley provides comprehensive and up to date tax information covering:

  • Calculating the tax benefits of incorporation
  • Effective rates of tax on profit
  • Timing of remuneration
  • Form of remuneration
  • Shared ownership
  • Administrative considerations
  • Specific tax reliefs
  • Corporation tax reliefs
  • Reliefs available to investors

Calculating the tax benefits of incorporation

The Incorporation ― introduction and procedure guidance note details some of the key reasons why an unincorporated business may wish to incorporate. From a tax perspective, there are two key factors that will apply to all businesses considering incorporation:

  1. a different effective rate of tax on extraction of profits

  2. flexibility over income in respect of the timing and form of remuneration

In addition to these general factors, there will often be specific tax issues which may benefit particular business circumstances. There are a number of reliefs that are not available to unincorporated businesses. These reliefs may either relate to the taxation of the business’s profits or to its investors.

Effective rates of tax on profit

To ensure that a comparison of tax rates for sole traders and companies is meaningful, it is important that calculations compare like for like. It is therefore not useful to compare the rate of income tax and NIC on profits of a trade only with the rate of corporation tax. The sole trader is absolutely entitled to the profits after tax, whereas, the shareholder is not. Instead, we need to consider how the profit is to be extracted from the company to put the proprietor in the same position.

In the case of an ongoing company seeking to provide cash to a shareholder, the most efficient method is paying a salary up to the point that NIC becomes due and then dividends thereafter. The most relevant comparison therefore is between the effective tax rates on sole trader profits and dividends, accounting for all relevant taxes. This comparison assumes that the profit for income tax purposes is the same as that for corporation tax purposes but the rules for calculation of profit for income tax and corporation tax purposes have significant divergences that are worth considering (see below).

The following effective rates apply in 2021/22:

Sole traderCompany
Basic rate

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