Employed, Self-Employed or Incorporated?

Below are some sample numbers to illustrate where self-employment fits into the scheme of things.

Here is a three-way comparison between three main options:

1. Employment All earnings/income are assumed to be drawn as salary, meaning that there is employer’s and employee’s Class 1 NICs at combined rates of up to 25.8% and income tax at rates of up to 45%.

2. Self-employment All profits are treated as income, with Class 4 NIC at up to 9%, Class 2 at £2.85 a week and income tax at rates of up to 45%.

3. Incorporation Profits are assumed to provide a salary of £8,164 (the primary and secondary NIC Class 1 threshold), with the balance subject to corporation tax at 19% and the remainder distributed as a dividend. There are no NICs, but dividends are subject to rates of up to 38.1% once the dividend allowance is exhausted.

In practice, once the personal allowance is less than £8,164 (ie dividends are at least £98,508) there is a very marginal advantage in paying only enough salary to cover the available personal allowance, subject to the lower earnings limit (£5,876 in 2017/18) being covered. Similarly, if some Employment Allowance were available, this would favour a higher salary of up to the personal allowance. These two possibilities have been ignored in the calculations below because the overall saving is generally minimal.

In every instance employment (1) comes out as the worst option from a net income viewpoint because of the impact of 13.8% employer’s NIC and, up to £45,000 of earnings, 12% non-tax-relieved employee’s NIC.

The difference between self-employment and incorporation is variable as the table below shows, which assumes a £2,000 dividend allowance, no Class 2 contributions and current tax rates, bands and NIC thresholds. There are three main factors driving the relative attractiveness of incorporation:

• At all levels, there is no NIC on the incorporated route – this drives the improving gain up to the £45,000 level, at which Class 4 NICs drop to a marginal 2%.

• The lack of grossing up means that, for any given profit level, there is less taxable income under incorporation. This shows up at two thresholds – the higher rate threshold and personal allowance threshold:

1. the higher rate threshold – hence the 6.37% gain at £55,000;

2. the personal allowance threshold – hence the 5.95% gain at £120,000; and

• Once dividends are attracting higher or additional rate tax, the marginal tax rate favours self-employment at 42% v 45.325% (higher rate) and 47% v 49.861% (additional rate). This higher marginal rate explains why the advantage of incorporation fades as each threshold is left behind.

By the time profit is over about £145,000, incorporation is the costlier option.

These are purely tax and NIC driven calculations. The choice between self-employment and employment should not be made on bare numbers alone.