Tax efficient profit extraction for business owners
You’ve worked hard to set up your business and things are going well. You want to reward yourself for your efforts. But how do you take money out of your business in a way that is both tax efficient and right for you?
There are a number of factors that need to be considered when extracting profits from your business. First and foremost, you should think about the tax you will pay on the money you take out of your business. The nature and structure of your business, your lifestyle needs, and personal goals are also important factors to look at when choosing the right option.
Main ways to extract profit
There are several options business owners can use to take money out of their business. The four main ways are:
- Sale of the business
Salary vs dividends
The age-old question of ‘salary vs dividend’ is important not just from a tax perspective but in considering the numerous commercial, financial, personal and longer-term consequences of choosing the ‘correct’ combination of the two.
Dividends can be paid to anyone who owns shares in the business providing the company has enough profits or reserves.
In 2017/18 the first £5,000 of dividends were tax free, but this was reduced to £2,000 per annum in the 2018 budget. Any dividend amounts over the newly reduced allowance are taxed at the banded rates shown in the table below. Dividends, unlike salary, are exempt from National Insurance Contributions but they are not a tax-deductible expense for corporation tax purposes.
From a tax perspective taking a modest salary alongside dividends can be beneficial. By taking a minimum salary below the income tax rate threshold (£12,500 for 2019/20) and keeping your salary just above the qualifying threshold for a state pension, you can make the most of your wage.
The table below shows the differences between the salary vs dividend options for consideration:
|Can be paid if loss-making/no reserves||Requires profit or reserves|
|Guaranteed contractual income||Based on profitability; not guaranteed|
|Can be tailored individually||Based solely on shareholdings|
|Deductible against profits||Not deductible and subject to corporation tax|
|Subject to NICs at 12% – 2% employee and 13.8% employer contributions||No NICs due|
|Qualifying earnings for pension purposes||Non-qualifying earnings for pension purposes|
|Effective tax rates 20% (basic rate band) 40% (higher rate band) 45% (additional rate band)||Effective tax rates 7.5% (basic rate band) 32.5% (higher rate band) 38.1% (additional rate band)|
|Used by mortgage and credit provider||Not counted by mortgage providers|
|All tax paid to HMRC by employer||Residual tax paid up to 21 months later by recipient|
|Counts towards National Minimum Wage and state pension||Not counted towards National Minimum Wage or state pension|
When it comes to saving for retirement, you could see some immediate benefit from pension contributions. Pension contributions allow you to extract profit from your company while still benefiting from tax relief.
If the company pays into the pension fund, this money isn’t treated as a taxable benefit on the individual but it is deductible for corporation tax, meaning it is tax efficient.
There is currently a £40,000 limit on the contributions made into an individual pension pot each year. This is however, reduced for any person with an annual salaried income that exceeds £150,000.
When withdrawing money from your pension pot, the first 25 per cent is tax-free. After this, any withdrawals will be taxed at the current tax rate, which is generally lower than at the time the money is paid into the scheme.
For hospitality businesses it is also worth considering how the use of a Tronc scheme and its tax benefits can factor into the profit extraction practice.
Another option could be to ultimately sell the company. If the company is a trading company shareholders could be entitled to Entrepreneurs Relief. The owner would pay 10% tax on the sale of the shares, but any remaining profit within the company would have already been subject to corporation tax at the current rate.
If you are considering business sale as an option, it is wise to consider how easily you can sell the company and whether it will generate enough capital to achieve your goals – whether they are funding for a new venture, a career change, or retirement.
If you are viewing your business as your ‘pension’ it may be worth considering contributing to a personal pension alongside this as it remains a ‘better’ tax rate and can be more secure.
The optimal solution
Ultimately, the optimal solution is about balancing a combination of options to make the most of your money and all available tax reliefs and allowances.
As well as the four options detailed above, you may wish to consider benefits (life & health insurances, phones, tax efficient vehicles etc), renting personally owned assets, bonuses, loans and interest on loans, personal expenses and family tax planning as options for maximising your renumeration package.
How we can help
What is best for you will depend on your lifestyle needs, personal goals and your commercial situation. With so many options available, it is advisable to seek advice.
To make the most of your tax situation we can review any current renumeration strategies and help you plan for the future to make the most of your money.
To arrange a remuneration review, contact Victoria Nicoll.