Posted by Joy & Co Chartered Certified Accountants on 12th January 2014
I’ve seen on a number of occasions first time directors of one man band limited companies getting confused about the various taxes that come into play when they start running a limited company. This blog post is concentrating on income tax and corporation tax as this is where I see the most confusion and I am often asked “Why am I paying income tax when I’m a limited company?”
The first thing to keep in mind is that a limited company is a separate entity or person from you. You are you and the company is the company. As the director/shareholder you own the company and tell it what to do but it is separate from you. This is clearly different from a sole trader set up where you and the business are the same person.
The second thing to remember here is that human beings pay income tax while limited companies pay corporation tax. Once you’ve got your head around that then everything else falls into place.
When trading as a limited company all of the money is earned by the company – not by you. The fact that you physically do the work is irrelevant. The contract to provide a service is struck with the company and the company then sends you, its employee, out to fulfil that contract.
At the end of the accounting year the company calculates it’s profit, i.e. all the money it’s earned less all the expenses incurred to earn that money, and it pays tax on those profits. The tax that the company pays is called corporation tax.
So where does income tax come in to the equation? Well take a seat and let me tell you.
As previously mentioned when a company enters into a contract it sends you, its employee, out to fulfil that contract. Now if you have any sense you’re not going to want to work for nothing. You want some reward for all this hard work you’re doing. But you can’t just take the money from the company because it’s not your money. It’s the company’s money and the only way to get it out so that it’s yours for ever and ever is: you make your company pay you.
Broadly speaking there are two main ways your company can pay you – either by salary or dividend. Of course there are more fancy and complicated ways of getting the money out but we’re just going to concentrate on salaries and dividends here.
So now you’ve got your company to pay you say £30,000 as a combination of salaries and dividends. This is income for you and it is a sad fact of life that almost all income (and certainly salaries and dividends) are taxable.
Now remember near the beginning when I said that companies pay corporation tax and human beings pay income tax? Well you, the human being, now have to pay income tax on the £30,000 that you’ve received from your limited company.
So the next time you wonder why you still have to pay income tax when the company has already paid corporation tax, just remember this. The company has given you a load of money. This money is income for you and therefore taxable. You are a human being and therefore pay income tax on it – end of story.