Taxation for Citizens of any Country - Essay Example

Running head: Business Taxation Business Taxation (United Kingdom Tax System) Due: Business Taxation (United Kingdom Tax System) Taxation is unavoidable for citizens of any country that either are in business or employed by various companies. The taxation system in the UK involves payments to the tax authorities or as charged when buying a commodity. With regard to this, her tax system is divided into direct and direct form of taxation. Direct taxation occurs on charges of income from individuals or corporate, profits earned in business or other gains, these forms of taxation is deducted at the source or paid directly to the authorities. Indirect taxes are charged on the goods bought by individuals. This often inclusive of the value, which the item was sold at. According a journal therefore understanding the different forms of taxation and meeting their obligations is of great importance to any business. One can save money by understanding what taxation involves in a given type of business whether a sole trader or partnership. As stated in the Tax Advisor (2012), a businessperson would also take advantage of any exemptions that they might be entitled to which would at the end boost the business. This paper will explain the terms and concepts in business taxation that will aid a clear understanding; it will assess the consequences that come as a result of incorporating a sole trader business, recommendations to the trader and finally whether the business qualifies for capital gains tax incorporation relief. Terms and Concepts Sole trader A sole trader is a person who runs and operates a business on their own. The sole proprietor is liable for all the assets and liabilities of the business. Moreover, sole traders have full control of their business with all the profit. In 2012, The Tax Chartered Advisor stated that the taxation system for a sole trader in the UK allows one to complete a self assessment of their business. In this form, the sole trader is allowed to show total expenses, the total income and then subtracts to get the losses or profit for the business. Should the company show a loss then it does not owe the government otherwise, the business is taxed depending on the profits earned. Incorporated or Limited Company An incorporated company is a form of business that is owned by one person who is the director with employees working for the company. This type of business is not solely owned by one person and decisions regarding the company are made as a group. Implications of the Two Business Structures With the new tax rates that were released in the UK, it has been realized that the best way to save money by avoiding paying a lot of taxes is through the start of companies. According to Payroll Practitioner (2009), the tax adjustments made favors limited companies unlike the sole proprietors. This is because of the following reasons: When one is the owner of a corporate company, they often pay dividends, which according to the tax rates; they are, taxed less than other forms of income. In case one starts a company with their wife, they often share the profits which results in a lower tax than when the profits are taken by a sole proprietor, moreover corporation taxes are much lower than income tax rates. However, with this in mind, the question is whether the transfer from a sole trader to a limited company has any consequences. Tax analysts (2012) believe that the issue of tax is a problem that most businesses have to deal with. However, as earlier stated the corporation taxes are much lower than the income tax rates. When a sole trader’s business is incorporated, it implies that the company is limited by shares. There is usually a procedure to be followed when this is done. Firstly is the registration of the company name, next a date is chosen for the transfer of the business and an agreement is reached between the parties involved to enter a contract and all the assets of the sole trader transferred to the new company in return of the shares. Incorporating a business removes the burden of tax only in a scenario where the owner of the company draws their profits as dividends rather than income. Drawing their gains as dividends allows them to avoid double taxation by the relevant authorities. Take an example where the owner of a given company has taken the gains as salary, in this case they risk being taxed at the income tax rates just like a sole trader’s income. On top of this, they would be taxed as employees of the same company and hence should contribute to the national insurance. This is because the tax system treats the company and the owner as different legal entities and the owner is subject to taxation like any other employee. Thus according to Lexis (2012), in terms of tax it is advantageous to trade through a limited company but the boss should remember to draw the income as dividends that are taxed at a lower rate. In addition, the amount of dividends should fall at a lower bracket rate of 40%. He continues to assert that in case they draw their dividends without restriction on the lower bracket they risk being taxed at 22.5% on excess that would be a tax rate burden to them too. In contrast, he asserts that self employed persons also are taxed at income tax rates based on their profits that are often added to other sources of income. As earlier stated, income tax rates are higher than corporation tax rates. In Addition, national insurance contributions of class 4 are applied on the business profits often restricted at 7% bracket. On top of it, national insurance class 2 is also paid by self employed persons although these are lower than those paid by company directors. Some may wonder why all this is happening, it is true that due to the poor economy the government is encouraging people to invest in limited companies as this will allow profits to be retained in the business that will boost the economy in the end. However, should the sole proprietor make profits they will be taken out of the business and be misused rather than being retained in the economy. Recommendations According to Tax analyst (2012), the government charges more tax on sole traders than in partnership since it wants to restore the economy of the country. With this in mind, the taxation system more so favors the corporate than the self employed. There are several factors one might look at before deciding to change from a sole proprietorship to an incorporated company but tax has been the most outstanding. The recommendation would involve a number of calculations on both sides of the sole trader and the company in terms of tax and how much all of the business structures would fetch. Finally, a recommendation on which business structure most suites Ben. While calculating the income for Ben from both the business structures the following things are taken into consideration: Income from the given business structure, national insurance contributions, and capital gains. Sole proprietorship To illustrate the above, the example of Ben would be legible to the following deductions: Income tax rate will be =40/100 x 60,000 (since Ben falls in C of business persons earning between 37,401-15,000 pounds) =24, 000pounds. Ben is further entitled to national insurance class 2 of 104 pounds and further on the national insurance class 4 of 1,806 pounds payable for all self-employed persons. In total, Ben pays a tax of 25, 910 pounds. Incorporating the Business In a clear understanding on what happens should Ben incorporate his business. Since Ben took the profit earned his salary, he will be entitled to a similar tax just like when he is operating as a sole trader =40/100 * 60,000 (since Ben falls in C Of businesspersons earning between 37,401-15,000 pounds) =24, 000pounds. According to Lexis (2012), Ben should further be entitled to a national insurance contribution of 12.8% on their salary which is 7,680 pounds which would be more headache since the total tax would be more than what is paid in the sole trader business as he took the benefits as salary and not dividends. For one to change their business from sole trader to corporate company there are things they need to know regarding how the UK tax system works. The government is after rebuilding the economy and the corporation will be the best option for any individual. However, when it comes to the time of transfer of their benefits from the company they need to take it as dividends not as income. In the example above, Ben took intends to take his gains from the company shares as income and this has made the tax to go high. On top of this, taking the company profits as income calls for taxation from the government as a self employed person and at the same time tax as the employee of the company. As earlier stated, this happens because a corporation is taken as its own entity and therefore the owner is different from the company itself. Therefore, before recommending Ben on the best option to take, there are other factors that one needs to consider when incorporating their business not only the tax factor. According to the Tax Chartered Advisor (2012), pension planning is another factor. The fact that companies do not recommend one to take the gains as salaries implies that there are no earnings directly as salaries, which would further mean no pension contributions. However, the advent of stakeholder pension plans has made it possible for large amounts to be contributed each year as pension. Nevertheless, if one does not wish to contribute their money to the stakeholder pension plans they can alternatively use their “earnings” for five years to act as income for their next couple of years even if they still would not be earning in the remainder of the other years. It is comforting to know that entitlement to basic state pension is not affected by taking a salary from the company at the level of a person’s personal allowances. In case one does not want to transfer their funds through the stakeholder pension plans they have another option of investing in ISA of which there would be no salary should you take that option of investing in ISA. In conclusion, it would be advantageous in terms of tax and other factors to incorporate a business but however it should be done carefully and with much caution. Thus, there is a need for planning to avoid regrets or frustrations and the sole proprietor need to understand what it takes in order to change their business to a company. An incorporated business protects an individual from personal liability and thus it is advantageous. Moreover, the tax system favors the incorporated business unlike the sole trader type of business. Capital Gains Tax One who holds a business, or is in partnership in a company where they own shares may be entitled to some tax reliefs that reduce their expenses. This type of tax is due when one sells, or gives away their business, or disposes their business assets. However, there are different rules that would be followed for one to be legible to get any form of incorporation relief. It follows that some assets would count as business assets for one type of relief but fail in another type of relief. Some reliefs are given automatically if a business asset is entitled to the same while others are claimed. When Ben’s assets were transferred to the company at that time capital gains tax may not be due however he is entitled to receive an incorporation relief. Conditions for Incorporation Relief For one to qualify to receive an incorporation relief, they must transfer all their business including the assets apart from cash to the new company as a going concern. Once they have transferred their business they in return receive shares in the company. In Ben’s examples, all assets were to be transferred to the new business and thus he would be entitled to an incorporation relief automatically. The assets would be sold on the market value and thus he was expected to calculate the cost of the shares. In calculating the cost of shares the business need to take into account the original gains that they are to receive (Nexis, 2012). Procedure in calculating incorporation relief It is calculated when one sells or disposes the shares received after the transfer of their business. After that, they then work out the tax due by reducing the cost of the shares of the amount of the postponed gain. The cost of shares is 100,000 pounds and the original gains is 60,000 pounds. Thus to find the cost of shares to include in the calculations of the incorporation relief it would be 100,000 pounds less 60,000 pounds which is equivalent to 40,000 pounds. References Lexis, L, 2012, Tolleys Taxation, viewed 2 March 2012. . Nexis, L, 2012, ButterWorths Tax Journal, 2012, viewed 2 March 2012. . Payroll Practitioner, 2009, Payroll in Limited Liability Companies, Snap, London. pp. 1-15. Tax Advisor, 2012, Chartered Institute of Taxation, Knaps publishers, Oxford Tax Analysts, 2012, Tax News and Analysis, viewed 2 March 2012. . Appendix A table that compares how the two business structures are taxed: Sole Trader Limited Company Income Tax Income Tax Corporation Tax First £7,475 0% - - Next £35,000 20% You choose your salary and therefore your income tax First £300,000 of profits taxed at 20% Next £107,525 40% - - Over £150,000 50% - - Tax is due in January and July Tax due nine months after year end The most widely used structure for smaller businesses making decent profits is to be a Limited Company, paying a small salary, claiming expenses and taking the rest as dividends. The table below shows the National insurance taxation that is most often hidden from the business persons. National Insurance (the hidden tax) Sole Trader Limited Company Remember - NI is really income tax Class 2 = £2.50 a week Employees NI Employers NI Class 4 = 9% of all profits above £7,225 12% of salary between £7,228 and £42,484 13.8% of all salary above £7,072 Class 4 = 2% of all profits above £42,475 Then 2% of the rest - (This is an income tax and national insurance on profits) Choosing the salary by a limited company hence the NI bill Sole traders pay a fixed weekly charge then a further NI charge on their profits on top of income tax. On the part of the limited company once one takes a big salary they risk high taxes. Which means they contribute as employees and employer implying that : At the lower rate they would pay 20% + 12% + 13.8%= 45.8%, however at the higher rate they would pay 40% + 2% +13.8% =55.8%. It is therefore advisable to take a less salary from the company and the other cash as dividends which have favorable tax rates. To illustrate the above, the example of Ben would be legible to the following deductions: Income tax rate will be =40/100 x 60,000 (since Ben falls in C of business persons earning between 37,401-15,000 pounds) =24, 000pounds. Ben is further entitled to national insurance class 2 of 104 pounds and further on the national insurance class 4 of 1,806 pounds payable for all self-employed persons. In total, Ben pays a tax of 25, 910 pounds. Incorporating the Business In a clear understanding on what happens should Ben incorporate his business. Since Ben took the profit earned his salary, he will be entitled to a similar tax just like when he is operating as a sole trader =40/100 * 60,000 (since Ben falls in C Of businesspersons earning between 37,401-15,000 pounds) =24, 000pounds. According to Lexis (2012), Ben should further be entitled to a national insurance contribution of 12.8% on their salary which is 7,680 pounds which would be more headache since the total tax would be more than what is paid in the sole trader business as he took the benefits as salary and not dividends. Read More