SIPPs for Corporation Tax Reduction

In November 2022, Chancellor Jeremy Hunt announced that everyone would have to pay a bit more tax as a result of his Autumn Statement. The effects of these measures are already being felt, as HMRC’s latest tax data reveals that receipts from income tax, capital gains tax, national insurance (NI), and inheritance tax (IHT) have all risen sharply compared to the previous year.

But while income tax and IHT have made headlines, the situation with corporation tax is even more striking. The government has seen a 17% increase in corporation tax receipts, amounting to nearly £30 billion over a four-month period. This increase is due to the top rate of corporation tax being raised from 19% to 25% in April.

This means that many business owners will see more of their profits going to the taxman in the coming years. However, with some planning, there are ways to mitigate this tax burden. One such way is for directors of private limited companies to use self-invested personal pensions (SIPPs) to protect their profits.

So, how does the new corporation tax regime work? There are now two main rates of corporation tax. For profits under £50,000, a rate of 19% applies, while profits over £250,000 are taxed at 25%. If a private limited company’s profits fall between £50,000 and £250,000, it pays tax at the main 25% rate, reduced by a marginal relief. In short, this means that companies in this profit range pay less than the top rate.

It is important to note that this new regime was announced in the 2021 Spring Budget and was approved by Chancellor Hunt earlier this year. The previous chancellor, Kwasi Kwarteng, initially proposed keeping corporation tax at 19% in his emergency mini-Budget in September 2022. However, Hunt reversed this decision shortly after Kwarteng’s resignation.

Many people may assume that corporation tax only applies to large companies with multiple employees. However, of the 5.5 million UK private sector businesses, 74% do not employ anyone aside from the owner(s). Many of these businesses are effectively one-person operations. Freelancers and contractors often structure their affairs as private limited companies for tax benefits. The increase in corporation tax rates could squeeze these benefits, especially during a time of increasing living costs where every penny counts.

Despite the recent increase to 25%, corporation tax receipts have been rising sharply for almost a decade. In 2013-14, payments totaled £38.93 billion, but by 2022-23, they had doubled to £78 billion.

So, how can pensions help directors save on tax? Owner/directors of private limited companies typically have three options to withdraw profits: take it as salary, receive dividends, or contribute to a pension. If the money is needed for everyday expenses, a pension may not be the best option, as it cannot be accessed until the age of 55 (rising to 57 from 2028).

However, when there is no immediate need for the money, and there are excess profits, it is worth considering the tax implications of each option. Let’s take a look at an example:

  • Company profit: £50,000
  • Salary/bonus: £50,000
  • Dividend: £50,000
  • Pension withdrawal: £50,000

In this example, the net benefit of paying into a pension is roughly double compared to receiving the money as a bonus or dividends. Company pension contributions are considered allowable business expenses and are exempt from corporation tax. They also escape employer and employee NI, unlike drawing money as salary. Limited company owner/directors can contribute up to £60,000 a year into a pension without the 100% earnings restriction applying. This is particularly beneficial for those who usually take a small salary and receive the rest in dividends.

It is worth noting that once a pension is drawn, the money becomes taxable. However, 25% of the sum can be withdrawn tax-free, and the rest is likely to fall within the basic-rate tax bracket, making the pension contribution a favorable option in terms of tax. Even if the individual pays higher-rate tax, the argument for contributing to a pension still holds. Additionally, pensions are typically considered outside of one’s estate, meaning the money is also sheltered from inheritance tax (IHT).

While it is important for everyone to prioritize pension savings, the situation is particularly pressing for self-employed workers. Research by IPSE (the Association of Independent Professionals and the Self-Employed) found that fewer than a third (31%) of self-employed workers are saving into a pension. This lack of saving could mean reaching later life with insufficient funds and potentially missing out on valuable tax breaks.

So, why do SIPPs suit self-employed workers? SIPPs are a great alternative for those without access to auto-enrollment. Self-employed workers, whether limited company owners, sole traders, or in partnerships, often have irregular earnings. The flexibility of SIPPs allows individuals to pause, stop, and restart contributions without penalties. It is common for business owners to make regular monthly payments and add a lump sum at the end of the tax year when annual profits are clearer.

Freelancers can also make personal pension contributions. While personal contributions receive an upfront 25% boost in the form of basic-rate tax relief, it is usually more tax-effective to contribute directly from the company for private limited company owners. Seeking help from a financial adviser is recommended to ensure contributions are both affordable and suitable.

Regardless of the chosen route, it is essential to remember that pension contributions offer attractive tax breaks that can help individuals reach their retirement goals. With careful planning and utilizing the benefits of SIPPs, self-employed workers can beat the corporation tax raid while securing their future financial well-being.