Starting a new law firm (Part 3): Tax

How you are taxed when setting up your firm depends on the business structure you choose. Outlined below are the different options and how these affect the way you pay tax.

Sole practitioner, partnership or limited liability partnership (LLP)

On setting up, you will be treated by HM Revenue & Customs as becoming self-employed, unless, in an LLP, you do not meet the self-employed criteria. Assuming you do, you will need to complete a self-assessment tax return and will stop paying tax under Pay As You Earn, making only two payments of tax per year in January and July.

Your tax will be based on personal income tax rates, which will vary between 20%, 40% and 45% (if you are subject to Scottish rates of income tax these will be higher) and calculated by using your share of your firm’s tax-adjusted profits, however much you have drawn from the business. This figure will not necessarily be the same as the profit on your accounts, as it will reflect adjustments for expenditures that have been deducted in the accounts but are not allowable for tax purposes, and also specific tax allowances (for example, capital allowances).

Once established, your tax will be based on your tax-adjusted profit. Previously, unincorporated businesses would be taxed on the profits generated based on the business’s accounting year-end. However, from 6 April 2024, all unincorporated businesses will be taxed on the profits generated in the fiscal year. If the business’s accounting year-end is 31 March (or 5 April), there are no adjustments required, and an individual will simply pay tax on the profits generated from the date they start to 31 March (or 5 April) in the first year. After that, they are taxed on their annual accounting profits.

If the business has a different year-end for their accounts, individuals will still be taxed on the profits generated to 5 April each year, but this will be based on profits within two sets of accounts. For example, if the business accounts’ year-end is 30 September, then, to calculate your taxable income in the 2024/25 tax year, you will need to take six months of profits from the accounts ending 30 September 2024 (the period April 2024 to September 2024) and a further six months of profits from the accounts ending 30 September 2025 (the period October 2024 to April 2025). Depending on when the second set of accounts is prepared, this can lead to estimated tax returns, which will require amending.

Where the accounting year-end does not align with the tax year-end, there will be additional work required to calculate your annual taxable profits.

Limited company

Limited companies pay tax at the corporation tax rate on the tax-adjusted profits of the company. The tax adjustments are similar to those discussed in the sole practitioner, partnership or LLP section above. The profits assessed to tax are after salaries have been deducted but before dividends have been declared.

There are some differences in capital allowances you can claim in a company to those of a self-employed individual, a partnership or LLP. For example, a company can claim the new ‘Full Expensing’ relief as well as Annual Investment Allowances (AIA), whereas the self-employed and partnerships or LLPs can only claim AIAs. However, for most businesses, this will make little difference to overall claims as AIAs can be claimed on qualifying capital expenditure up to £1m, so most businesses would not exceed that in any given trading period.

As an owner of the company, you will not be self-employed. You will only be taxed on the amounts you withdraw from the company. If you are taxed by salary, your income tax liability will be at the same rates cited in the self-employed section above and the company will receive corporation tax relief. If you are taxed by dividend, it will most likely be at lower tax rates, which can vary between 8.75%, 33.75% and 39.35% – however, the company will not receive any corporation tax relief. As this can become very complex, we would suggest reviewing your overall circumstances before considering how you are paid.

It may be possible to start as a sole practitioner, partnership or LLP and then later incorporate to become a limited company. In that situation, it may be possible to justify a goodwill value of your firm and sell that goodwill to the company for a lower effective tax rate. This is a complex situation, with other tax implications, which has changed in recent years, so advice is needed if you are considering this option.

Rates of tax

The current rates of income tax are higher than corporate rates. Companies pay corporation tax. There are several different rates of tax for a company; it can be 19%, 25% or 26.5% depending on the level of taxable profits.

When removing all profits from a company and being charged on the method of extraction, the tax savings generated in the company structure may be taken away. The overall difference is dependent on the amount of profits earned and withdrawn, and also on the tax rates in place at that time. Careful consideration needs to be given to how profit is extracted (dividends, salary or a mixture of both) and you should seek advice before you decide how you will be paid.

It may be possible to leave money in companies until they are liquidated or until your shares are sold. In those circumstances, the rate of tax on the balance remaining in the company could be reduced to 10%, if qualifying conditions are met, making it more attractive to use a company.