February 06, 2026
Article
Following the news in the Budget that the personal allowance and basic rate tax bands are to remain at the current levels until 5 April 2031, what is the effect of the fiscal drag on the tax paid by individuals?
The personal allowance has remained at £12,570 since 2020-21, however if this had been increased by inflation each year, based on a cumulative inflation rate during that period of 22%, it would now be in the region of £15,350 with the basic rate tax band amounting to around £46,000. A person could therefore earn £61,350 before paying tax at the higher rate - £11,080 more than at present and a tax saving of £2,216 per year. If inflation continues at a similar level until 5 April 2031, the personal allowance would have then been around £18,700 and the basic rate tax band around £56,000. A person could earn income of £74,700 before paying tax at the higher rate – a total saving of £4,886.
With the effective personal tax rate increasing in this way, many will be asking whether there are still benefits to incorporating a business – particularly in light of the 2% increase in tax on dividends coming into effect from April 2026 and on rental and investment income from April 2027. As with most things, the answer is it depends!
A partnership of two people currently generating taxable profits of £200,000 per year will give rise to a tax liability of £30,688.60 each as follows:
This equates to £61,377.20 in total and an effective tax rate of 30.69%.
If that same business were run as a limited company and the after tax profits withdrawn in full by way of basic salary of £12,570 and the balance in dividends, from April 2026 with the 2% additional tax on dividends, the tax payable would be as follows:
Corporation tax would amount to £41,100 and the personal tax would be £14,431 each – (£28,862 in total). The total tax on the £200,000 profits generated would therefore be around £69,962 in total and an effective rate of 34.98%.
If the directors chose instead to withdraw £100,000 of the total profits by way of £12,570 salary and £37,430 dividends each and leave the balance within the business for reinvestment, the corporation tax would remain unchanged at £41,100, however the personal tax would reduce to £3,970 each - £7,940 in total. The overall tax would then be £49,040 and an effective rate of 24.52%.
If the partnership profits rose to £400,000, the position would be similar – if the business incorporated into a limited company and all the funds were withdrawn, there would be no tax benefit. If, however, a large proportion of the profits were retained within the company for reinvestment, a tax saving would arise.
The above figures are just a simple comparison of the tax payable without taking into account any additional tax planning opportunities for both individuals and companies such as pension planning, withdrawal against directors loan accounts, use of rent payments for property etc. It also assumes individuals do not have any income from other sources to take into account.
If owners are looking to grow and invest in their business, incorporation can offer significant tax benefits – particularly where profits are higher. There are however many tax implications of incorporating and advice should be sought in advance. Consideration should also be given at the outset to the succession plan and what the partners are looking to achieve in the long term – different aims will have different tax implications.