If you operate a moderately profitable unincorporated business, structuring as a company has traditionally delivered welcome income tax and national insurance savings. By taking a modest salary and extracting remaining profits as dividends, owner-managers secured lower personal tax bills thanks to the old dividend tax regime. But with chopped allowances and fattened dividend rates since 2016, are incorporation advantages now too trifling to justify the admin hassle?

How Dividend Taxation Changed

Up until April 2016, all dividends included a 10% notional tax credit, reflecting that payouts aren’t tax-deductible expenses for companies. This system meant basic-rate taxpayers had no extra dividend tax to pay, while higher and top-rate taxpayers still enjoyed lower dividend rates versus normal income.

Yet this favourable regime soon soured. In 2016, the tax credit disappeared, swapped for a £5,000 dividend allowance. More painfully, dividend tax rates increased for higher and top-rate taxpayers. The allowance has since shrunk to £1,000 for 2023/24, while an extra health and social care levy has further lifted dividend rates.

Miserly Allowance, Meatier Rates

That measly £1,000 allowance is less generous than it seems, too. It is not technically an allowance but a nil-rate band. So the first £1,000 of dividends are tax-free but still erode other allowances and can trigger extra charges. Dividends above the nil rate band are taxed at 8.75% for basic ratepayers or 33.75% for higher-rate taxpayers.

The combined effect of base corporation tax, elevated dividend rates after 2016 and the health levy means total income tax can now approach 50% of company profits extracted as dividends. As profits increase, the logic of incorporating tax savings needs to be more questionable.

Silver Linings For Lower Profits?

Yet 2023 has brought a glimmer of sunlight for small companies delivering under £50,000 in profit. The small profits corporation tax rate stays 19% this year, while marginal relief cuts the effective tax rate to 26.5% for profits from £50,000 to £250,000. For more modest businesses, incorporating may still substantially reduce income tax and national insurance versus operating as a sole trader.

Assuming sensible salaries are drawn to minimise national insurance, a firm making £40,000 profit might save an owner-manager around £7,500 in income tax and class 4 NICs annually through incorporation. Even at the £100k profit mark, the savings could approach £15,000. Therefore, incorporation can unlock worthwhile tax savings, especially if profits exceed £50,000.

Future Upheaval?

Whether the existing regime persists is questionable, given the economic outlook. The government previously proposed taxing small company profits as personal income, although this seems shelved. But with ballooning national debt after COVID, stealthier tax grabs likely await. More dividend, salary or company profit tax pain seems possible.

To Incorporate or Not Incorporate?

For moderately profitable sole traders, incorporating as a company can still provide substantial income tax and national insurance savings versus remaining unincorporated. But the advantages have diminished thanks to repeated dividend disincentives since 2016. Before switching, micro firms should consider likely future profit levels.

If you can reliably forecast profits below £50,000 ongoing, becoming a company makes sound financial sense thanks to the lower small profits corporation tax rate. Just keep salaries modest and extract surplus profits as lightly taxed dividends. Even at the £100k mark, incorporation still saves around £15k tax versus sole trading. But as profits approach £200k, the benefits look less alluring.

With no crystal ball for future earnings or taxes, unincorporated companies should model scenarios with their tax accountant to determine if incorporation still promises superior returns despite the recent squeezes.