6

I currently have a 'day job' as a web designer. I am considering taking on some freelance work which I have been offered and this would be completed in evening/weekends whilst also retaining my day job.

I am trying to work out the most tax efficient method of operating these 2 income streams together.

I am confused by how much tax i would pay (ignoring deductions for now) if i chose to operate the freelance work as a limited company.

  • My day job salary is currently £49000 per year
  • My projected income Jan-Dec this year from freelance is £26500

From my initial investigation it would appear that by using a limited company setup, I would pay 20% corporation tax on the freelance income and would be able to pay that money to myself as a dividend which would incur no further tax. Is this correct?

If not, what would be the most tax efficient method of operating?

  • Tax questions are always subject to local laws. As such, getting your tax advice from the Internet is unwise as the Internet is global. It is best for you to seek advice from an accountant or lawyer who is familiar with the laws to which you are subject. – Jack Swayze Sr Jan 1 '16 at 18:47
  • 4
    @JackSwayzeSr That's why we use country tags -- so that people who know about U.K. taxation can provide some information that is relevant to the question. – Chris W. Rea Jan 1 '16 at 22:00
  • Taxation of dividends Is going to change radically soon so you need to talk to an accountant – Pepone Jan 4 '16 at 21:09
  • As a side point, your Jan-Dec income doesn't matter, it's your 5th April to 4th April income that does. This means your next 3 months may want different logic applying to it than the following 9, as you're spread over 2 tax years. – Matthew Steeples Jan 5 '16 at 23:45
2

I am not an accountant so YMMV. Also, tax rates change as they have since the question was posted.

In the UK salary employees are paid each month after all taxes. Most UK citizens simply don't think about tax. When you are a freelancer you pay the tax bills yourself. As per the calculations below you may find you pay more taxes than a typical salaried employee. A newbie error is to spend the income as a dividend to then get a big personal tax bill the following year. The tax office asked me for the previous years dividend tax plus half as much again as a "payment on account" against the estimated next tax bill. Tax suddenly gets very real when faced with a tax bill covering one and a half years. Taking out money to pay that tax bill then attracts more taxes the next year. While you are happily living as Neo in the tax matrix today if you become a freelancer you will need to take the tax red pill.

My estimates of the taxes are as follows. Your company will pay corporation tax. You personally will pay tax on any dividends you draw. The good news is that you get a tax allowance on the dividend you draw and the rates paid on dividends are lower than for normal salary. The bad news is that HMRC applies both taxes and IMHO they seemed designed to try to make you pay at least as much as the tax on a salary. As at 2019 the top google search result says:

The tax-free dividend allowance is £2,000. Basic-rate taxpayers pay 7.5% on dividends. Higher-rate taxpayers pay 32.5% on dividends. Additional-rate taxpayers pay 38.1% on dividends.

The really bad news is that you are almost a higher-rate tax earner on your current day job. As at 2019 the higher rate tax bracket starts at £50k and is 40%. Let us assume your salary today is £50k. Any income you draw from your company as a dividend will be hit at the higher-rate of 32.5%.

Assume your company invoices £26k and pays 20% corporation tax that's £5.2k company tax. Then you pay £6.1k personal tax which is 32.5% on (£26*0.8)-£2k where the £2k is the dividend tax allowance. So the total tax on the invoice is £11.3k. That is an effective tax rate of 43.5% which is higher than the 40% salary tax rate you just hit.

Your company does get to keep some VAT that you pass through. As you won't have a lot of costs you will be a “limited cost trader”. Today VAT is 20% that you add to your invoices and as a limited-cost trader, you forward onto HMRC at a rate of 16.5%. So that will be £1.6k a year your company keeps on top of the amount you invoiced. Yet that additional income is subject to all the same taxes as outlined above.

You only pay corporation tax after expenses. For freelance developers, expenses are not as generous as people seem to think. Even if you work from home a full day you cannot expense your lunch. The money your company can pay you to use your home as an office tax-free is a pittance. If you travel to visit a client you get some expenses such as a reasonable lunch and the cost of the travel but it isn't a significant amount. I don't think of business expenses as a perk; they are just the cost of doing business. You can do also do some client entertaining tax-free, yet that's a perk for them, not you. You can skip that and put money into a company pension plan and that would be buying entertainment for you when you hit 55 when you can take out a tax-free lump. That really is a perk.

Your company can buy some amazing computer hardware before taxes. Yet it is a waste of money to be doing that every year. It can buy a top range company phone but the SIMM only contract is a taxable benefit. Your personal tax bill will swell to include 40% of the SIMM contract cost. That is saving over buying a personal contract from your salary, but it doesn't really excite me. In the UK small companies don't get the huge discounts that UK consumers get. For example, you will pay charges for your company bank account and in the UK we are used to getting free personal-banking. IHMO you get hit with a lot of unexpected costs so it really isn't as rosy as people think. YMMV.

Your company can spend up to £300 a year on employee entertaining. Every year my wife and I enjoy a very exclusive company Christmas Party for two at a top restaurant. Bizarrely your company can give you a couple of hundred pounds of gifts tax-free each year as a "thank-you" as long as it isn't performance-related. Gifts cannot be cash but they can be a few hundred pounds of Amazon vouchers. Those perks along with buying yourself your dream computer and a top company phone do make it feel like you are winning; even if it is the taxman who is having the most success.

Once you take the red pill and see a few tax bills you might suddenly take a very keen interest in tax efficiency. My tip is to track the money of every paid invoice and assume the worst possible taxes on that invoice. By overestimating the taxes you will always be able to pay the tax bill and your company bank balance will grow. When it is about six months worth of money to live off then start creaming it off into a pension.

The most tax-efficient thing you can do is live off your main job and don’t spend the company money. The company account can then be your “rainy day” account for “life events”. If you ever lose your main job you can take out company money very efficiently. Let's say you lose your job on the last day of the tax year. You can then draw dividend up to the full personal tax allowance plus the dividend tax allowance without any personal tax. That is £14.5k tax-free. You will then pay only 7.5% dividend tax on the next £35.5k up to the higher-rate tax income. So that is only £2.6k of personal tax on 50k of dividend. You will then be laughing while the taxman isn't. You could quit your job and travel around the world doing freelance remote work enjoying those tax benefits and be really winning.

|improve this answer|||||
1

If you had earned that this year you would have to pay roughly £10,600 tax (between corporation tax and dividend tax) on your freelance work based on the calculator here - https://www.nixonwilliams.com/dividend_calculator.asp

The tax on dividends is changing in April 2016 to a different sliding scale. However, this might not affect you that much as you are already in the higher tax bracket from your salary so your dividends would already be quite highly taxed.

Any expenses you could put through your company would offset both the corporation tax and dividend taxes due.

|improve this answer|||||
  • Would opting to operate as a sole trader be much the same therefore, without the extra hassle of setting up and running a limited company? – Marty Wallace Jan 5 '16 at 16:08
  • Sorry, I don't know about operating as a sole trader as I work via my own limited company, but I assume the tax paid will be similar. – Richard Dalton Jan 5 '16 at 16:18
1

You are already paying income tax at the highest rate, so don't pay yourself a salary. You can pay a huge amount into a pension every year, which will be tax free (not sure if that is £25,000 or £40,000); a large portion of that you can later extract as a lump sum. After that payment and all your cost is deducted, the rest is profit on which you pay 20% corporation tax. That is unavoidable.

To extract money from the company, you can pay yourself dividends. Alternatively, you can leave the money in the company for any length of time which is tax free apart from the corporation tax that you already paid; you can then extract the money via salary and dividends when retire.

For example, if you don't extract any money now, your company will own £26,500 minus 20% after a year, that is £21,200. Do that for 20 years, then you can retire and extract £10,600 tax free salary and £10,600 tax free dividends for the next 20 years after that. Your company can also invest for example in real estate, or anything else that keeps and/or increases value.

If you need the extra money, then it doesn't make too much difference; you will pay a high tax rate anyway, but I think you'll be a tiny bit better off by paying dividends instead of salary.

|improve this answer|||||
  • But i would need access to the funds every couple of months - what is the best way to operate there? – Marty Wallace Jan 5 '16 at 16:09
  • Well, for every pound you extract as dividend now when you have a good income, you pay 32.5p in taxes. – gnasher729 Nov 27 '19 at 20:52

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.