In the third part of Armstrong Watson’s series on starting up your own firm, Andy Poole discusses the major tax considerations.

Tax is very much an extension of the business structure option and, in many cases, will be a deciding factor of that choice of structure.

Sole practitioner / partnership / limited liability partnership (LLP)

On setting up, you will be treated by HMRC as becoming self-employed, unless in a 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 and calculated with reference to your share of your firm’s tax-adjusted profits, irrespective of how much you have drawn from the business. This figure will not necessarily be the same as the profit per your accounts, as it will reflect adjustments for expenditure which have deducted in the accounts but is not allowable for tax purposes, and also specific tax allowances (eg capital allowances).

Once established, your tax will be based on your tax-adjusted profit for the year ending in the year of assessment. So, for example, your profit share in the accounts for the year ending 30 April 2019 will be declared on the 2019/20 self-assessment tax return. There are, however, special rules for commencement and cessation.

In the tax year in which you commence, you will be assessed on the profits arising from the date of your commencement to the following 5 April. Thus, if the first period end is 30 April 2019 and you commence on 1 May 2018, in 2018/19 you will be assessed on the profits arising in the period 1 May 2018 to 5 April 2019. Tax will be payable on those profits in January 2020.

Note that there can be a considerable delay between the date on which you commence and the date on which your tax payment is due. It is therefore important to make provision for this payment.

Special rules also apply to the second year of assessment, 2019/20 in the example above, which is based on the profits for the year ending 30 April 2019. The tax in this respect will be payable in two payments on account in January and July 2020, based on your 2018/19 liability, with a balancing payment if required in January 2021.

There is usually an element of double counting of profits in the opening years of an equity partnership. In the example above, profits for the period 1 May 2018 to 5 April 2019 have been assessed both in 2018/19 and 2019/20. A calculation is therefore made to quantify the profits assessed. This is called ‘overlap profit’. It is carried forward until your retirement, the partnership ceases or the year end changes when it is deducted from the profits assessable in the tax year of change.

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 the ones discussed in the sole practitioner / partnership / LLP section above. The profits assessed to tax are after salaries have been deducted, but before dividends have been declared.

As an owner of the company, you will not be self-employed. You will also be taxed on the amounts you withdraw from the company. If by salary, this will be at the same rates cited in the self-employed section above. If by dividend, it will most likely be at lower tax rates, although these rates have recently increased.

It may be possible to start as a sole practitioner / partnership / 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, and there have been many changes to the treatment of this in recent years; advice is needed if you seriously consider this option.

Rates of tax

The current rates of income tax are higher than corporate rates. Corporate rates are currently 19%, but due to reduce to 17% in the next few years. If removing all profits from a company and thus being charged on the method of extraction, the tax saving generated in the company structure may be taken away. The overall difference is dependent on the amount of profits earned and withdrawn. 

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 reduce to 10%, making it more attractive to use a company.

This article is very much a high level overview. This can be a complex area and advice should be sought from a specialist accountant on which route is best for you.

Andy Poolelegal sector partnerArmstrong Watson

Andy works exclusively in the legal sector advising law firms throughout the UK on strategic, structural and other business improvement issues as well as providing efficient accounting, tax and SRA accounts rules services.  Further information can be found at: www.armstrongwatson.co.uk/legalsector

This article is a general guide to the issues that we see in practice. It is not a substitute for professional advice which takes account of your personal circumstances. No responsibility can be accepted for any loss occasioned by any person acting or refraining from action on the basis of this article.

The legal sector team advises law firms throughout the UK on strategic, structural and other business improvement issues as well as providing efficient accounting, tax and SRA accounts rules services. 

The Law Society has exclusively endorsed Armstrong Watson for the provision of accountancy services to law firms throughout the whole of the North of England.