SMEs waste £7billion a year in unnecessary tax payments

Sole traders and partnerships that fail to incorporate their businesses by making them limited companies or limited liability partnerships account for the biggest area of ‘tax wastage’, at more than £4.2billion.

Unbiased, the professional services company who commissioned the research, says that 1.3million firms could benefit from changing their legal status. In partnerships, higher earners pay income tax at 40 per cent or even 50 per cent on their profits.

However, in a limited company the main tax paid is corporation tax – often 20 per cent for small firms – or dividend tax. And the owners have the added advantage that their liability for a loss made by the firm is capped.

Phil Marriott of TaxAssist Accountants in Shepshed, Leicestershire, says: ‘Incorporation has the advantage that owners can extract income via dividends, rather than salary.

‘These are taxed at a lower rate than income tax – typically ten per cent for small companies.

‘A partnership can also bring ‘‘goodwill’’, which is a measure of the value of the brand in the previous partnership, into the newly limited company.

‘The owner receives a credit for this in a director’s loan account, which can be withdrawn tax-free when the business makes a profit.’

However, Marriott warns that limited status puts greater demands on financial reporting. He says: ‘It won’t suit all firms. A good accounting system is necessary and owners can’t just extract income as and when they need it.’

Businesses could save a further £2billion by making more use of self-employed contractors, because they wouldn’t have to pay National Insurance contributions and holiday or sick pay.

Firms could also save £400million by claiming tax relief on research and development. In this tax year, R&D expenditure carries a 200 per cent deduction against profits, reducing a company’s taxable income. This will rise to 225 per cent in the 2012-13 tax year.

At present, only 12 per cent of eligible firms make use of R&D relief. Karen Barrett, chief executive of Unbiased, says: ‘A huge amount is wasted by small businesses failing to take advantage of allowances and tax credits.

‘Tax is a vast and complex subject and business owners often do not have the time to manage their tax affairs.

‘A professional adviser could help them understand their tax liabilities and make sure they are benefiting from any tax breaks available.’

Steve Parker is co-director of Dental Interiors, an installer of dental practices, which he set up ten years ago.

For years, the firm, in Coalville, Leicestershire, operated as a partnership, but late last year it was incorporated into a new limited company.

Steve, 41, estimates the move has saved him and his co-director, Simon Callaghan, also 41, £5,000 in tax payments each.

Steve says: ‘We see our accountant regularly and tend to follow his advice. ‘In this case, it was a move well worth making.’