INCORPORATIONS FOR PRINCIPALS AND ASSOCIATES – WHERE ARE WE NOW?

Date: 2009-09-22

July 2006 – the date on which dentists were first allowed to run their businesses as limited companies – is now well past us. So where are we now?

My experience as a tax practitioner has been that there was a flurry of interest in incorporations immediately after the rules changed, but that not all of this interest actually manifested itself in incorporations of individual practices. There was a similar upturn in interest as 5th April 2008 approached, stimulated by the imminent withdrawal of the valuable Capital Gains Tax Business Asset Taper Relief. Following the 2009 Budget changes and the announced increases in income tax rates and restrictions in pension contribution allowances (of which more later) one would expect a further upturn in interest, however this has still to make itself felt. The fact of the matter, however, is that most dentists have not availed themselves of the incorporation opportunity and thereby have continued to render themselves liable to the sledge-hammer of the self-employed current year basis of income tax self assessment.

Why ‘sledge-hammer?’ Because self-employed tax is based purely and simply on the profit as shown by the annual accounts as adjusted for tax purposes. Whether you have actually drawn these profits and made use of them for personal purposes is irrelevant; it’s the profits that count. So if your profits are £200,000 but you have only drawn £100,000 out of the business for personal use then your tax bill will be calculated using £200,000 as a starting point and not £100,000. As from 5th April 2010, thanks to the tax rate changes announced in the 2009 budget, this sledgehammer is destined to become a steam hammer. Fresh-faced on the scene from 2010/11 we have a 60% income tax band for incomes between £100,000 and approximately £112,950 (dependent on the personal tax allowance) and a new top rate of income tax at 50% for incomes in excess of £150,000. The anomaly of the 60% band has been created by the steady erosion of the personal income tax allowance where incomes exceed £100,000 until it dissipates altogether at twice its maximum level (£12,950 in 2009/10) after which the former 40% rate is restored until incomes reaches £150,000 as above. Added to all of these figures is the 1% Class 4 National Insurance charge which was introduced with effect from 2003 and which has no ceiling. This of course does not compare remotely with the top income tax rate of 83% which held sway in the closing days of the Callaghan government, but it’s getting there, and with the current rising level of national debt who knows what is to follow?

From a tax point of view therefore the attraction of incorporation is that it gives an opportunity to base your tax on what you draw rather than on what you earn. Profits come into it of course but these are subjected to corporation tax at substantially lower rates (21% on profits of less than £300,000 to 31st March 2010, and 22% thereafter) and once you have thrown this six to start then your tax will be based on what you draw – in the extreme case if you don’t draw anything then you won’t pay any additional tax. That is in no way the end of it since further variables will present themselves in the way you draw money from the company for personal use. The first of these will always be by means of salary and bonus (please treat with caution the advice of those who suggest that the salary can be limited to the level of the personal tax allowance and therefore be paid without deduction of any income tax at all. My view is that the salary must be set with an eye on commercial rates and I have Tax Counsel’s opinion which supports this view). Thereafter profits can be distributed by way of dividends which carry no liability to National Insurance and are paid net of a tax credit which completely covers the liability of basic rate tax payers and leaves an effective tax liability for higher rate tax payers of 25% until 5th April 2010 and 36.11% (for those with incomes of over £150,000) thereafter. For those who own the practice premises profits can be taken by charging rent which is subject to income tax (but not National Insurance) in their own hands but also represents a deduction for corporation tax purposes and therefore reduces the amount of tax payable by the company. (This would have an impact on a subsequent claim for entrepreneur’s relief). The most advantageous way for a Principal to draw money is however by capitalizing the practice goodwill and drawing from the company loan account thereby created and so effectively replacing income tax at whatever relevant marginal rate with capital gains tax at the businessman’s rate of 10%. These are four ways of drawing money; others may present themselves according to your circumstances.

The new tax rates may make incorporation a viable proposal for Associates. Associates cannot capitalize goodwill (since they don’t own any) but all other of the above breaks are available to them and they will not need to worry about the so-called ‘IR35’ tax rules (provided they use the standard British Dental Association or General Dental Practitioners Association contracts). A report commissioned by myself recently from a leading IR35 tax practitioner concludes that for the 2009/10 tax year an Associate with taxable profits of £200,000 using a company with two shareholders (one of whom has no other income) paying himself £30,000 in salary and with all other profits distributed equally by way of dividend can reduce the overall tax bill by £12,278. These savings will be squeezed in 2010/11 because of the increase in corporation tax and dividend tax rates.

So there it is. These remarks are limited to the tax situation but there are also other factors which may make incorporation attractive for you. There has been no better time to decide whether or not to take the plunge.

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