Tax planning for contractors

A qualified accountant should be the first person to provide detailed advice on effective contractor tax planning. The current structure of the tax system for limited company directors offers plenty of scope for saving tax for contractors and their families.

So how do contractors pay less tax? A typical independent contractor tax plan will contain a mixture of some of the following aspects:

  • Salary and dividend split
  • IR35 compliance
  • Appointing family members as shareholders
  • Claiming back allowable expenses from previous tax years
  • Pension contributions
  • Capital expenditure allowance allocation
  • Tax-free savings accounts
  • Special investment schemes
  • Single premium investment bonds
  • Members’ Voluntary Liquidation

Salary and dividends – tax planning at its most basic

Tax planning for limited company freelancers and contractors nearly always includes a recommendation to be paid with a mixture of salary and dividends. Significant personal tax savings can be made using an efficient split of salary (money paid to a director via the PAYE system) and dividends (distributions of after-corporation tax profits made by a company to its shareholders).

For example, at time of writing, receiving a salary of £46,350 via PAYE results in income tax and National Insurance payments of £11,441.12. An optimal salary/dividend split would result in a combined personal and corporate tax liability of £9,105, a saving of £2,336.12.

IR35 will affect any tax planning

Given the savings on tax that can be achieved by staying outside the scope of IR35, a contractor should make sure that the only contract work they or their limited company takes on falls outside the scope of IR35. If you’re contract is within IR35, most tax planning will be impossible to utilise, for example under IR35 you lose the ability to use the dividend mechanism altogether.

Appoint family members as shareholding directors

Further savings can be made by appointing family members, particularly spouses and civil partners, as directors of a contractor limited company. This way, both individuals can take advantage of their personal tax and dividend allowances during the year.

For example it’s actually more economical for a husband & wife team to split a £90,000 remuneration package equally between them, than for one director shareholder to take the £90,000 on their own, hitting higher tax thresholds.

This arrangement was established in the Arctic Systems ruling in 2007.

Claim back allowable expenses from previous years

Often, contractor limited company directors will switch from a mainstream accountant to a contractor specialist. Doing so often gives rise to expenses a mainstream accountant has not claimed for.

Upon changing accountants, there may be a significant gain for a contractor limited company director by asking their new accountant to examine previous years’ personal and corporate tax returns for omissions. This may result in a tax rebate.

Utilise pension contributions

Pension contributions nearly always form part of an accountant’s recommendations for independent contractor tax planning.

A contractor should always be comfortable with the level of investment they make into their pension. Many contractors will use pension contributions to move themselves from a higher to a basic rate tax band. An accountant’s advice should be sought on this.

Company contributions to pensions schemes are an allowable expense for corporation tax purposes. If a contractor limited company makes payments to a director’s pension, there are no personal tax implications for that director, meaning it’s usually financially a good idea to split some of your remuneration package into a pension.

Use your capital expenditure allowance

If a contractor limited company invests significantly in capital equipment, there may be a strong taxation argument to allocate the spending over two or more years to take advantage of the £200,000 per annum annual investment allowance. (From January 1st, 2019, the annual investment allowance in capital expenditure rises to £1,000,000 for two years).

Use tax-free savings accounts

For basic rate taxpayers under the Personal Savings Allowance, the first £1,000 of interest income is tax free. For higher rate taxpayers, the allowance is £500. There is no allowance for additional rate taxpayers.

There is no interest on savings held at National Savings and Investments. A contractor can also choose to invest money in interest-bearing premium bonds. There is no tax to pay on interest earned from premium bonds and on any winnings on premium bonds.

Invest spare cash in special investment schemes

There are significant savings that can be made on capital gains tax and income tax on investments in companies registered by HMRC on the Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS), and the Social Investment Tax Relief (SITR) scheme.

Or put your money into single premium investment bonds

Single premium investment bonds allow higher rate taxpayer contractors to not pay the tax on an investment until it has matured or the decision is made to cash it in. 5% of the value of investment can be taken out each year without tax being payable on the sum. For each year the 5% is not withdrawn, the allowance rolls over meaning that, after three years, 15% of the value of the investment is available to withdraw without having to pay tax on it.

Tax will need to be paid when the bond is cashed in if a contractor is a higher rate payer within that year. Tax can be avoided by ensuring that the bond is cashed in during tax years in which a contractor is a basic rate taxpayer.

The advice of an accountant or financial advisor should be sought when a contractor wishes to cash the policy in.

Members’ voluntary liquidations are a common way to extract profits

Many solvent contractor limited companies have a limited shelf life and, because of the minimal overheads and a tax-efficient strategy of cash extraction, a sizeable sum of money may still remain in the limited company’s account at the end of its useful life.

Rather than withdraw the cash in the account as a mixture of salary or dividends, there may be significant savings that can be made by winding the company up using a Members’ Voluntary Liquidation (MVL).

An MVL may bring a director the benefit of being able to take advantage of both Capital Gains Tax Entrepreneurs’ Relief and the annual capital gains tax allowance. Directors should seek advice from an accountant on whether this is a viable route and the potential for savings.

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