Tax efficient profit extraction

Introduction

One of the advantages of operating as a limited company is the flexibility it provides in how and when you extract profits form your business. Options include salaries and bonuses, dividend payments and pension contributions and interest payments on cash you've put into your business. Since the tax treatment is different in each case, this flexibility can be used as a key part of your overall tax planning.

Methods for extracting profit

Dividends

Dividends can be paid to any shareholders as long as the business is making sufficient profit to cover these costs. Under current tax rules a shareholder can receive up to £2,000 in any tax year before paying tax. After this tax is paid at 7.5%, 32.5% or 38.1%. The rate depends on your total level of income; meaning that after your £2,000 allowance has been used up you immediately start paying tax at 32.5% or 38.1% (skipping the lower rates). This would be the case if your salary, bonus and interest income for the year already exceeded your basic rate band or higher rate band.

The main advantage of dividend payments are that they are exempt all types of National Insurance Contributions (both for the Company and the owners), although dividends are paid out of post-tax profits; meaning they can't be treated as a business expense.

Remember however that dividends are usually payable to all shareholders; if you want flexibility in paying different amounts to different owners (e.g. paying less to shareholders not involved in day-to-day management) you'll need to issue different classes of shares and be careful that HMRC don't view this as a scheme to avoid tax or National Insurance Contributions.

Salary and Bonuses

For the company, paying Directors a salary and bonus means making National Insurance Contributions at 13.8% on most of the cost. On the other hand the total cost (including National Insurance) is a valid business expenses, saving the company 19% via reduced Corporation Tax.

The Directors pay Income Tax and National Insurance Contributions on the amounts received. Income Tax is paid at 20%, 40% or 45% depending on how much you earn and how you've chosen to apply your tax free personal allowance (see below). National Insurance contributions are paid at 0% (up to £162 per week), 12% (between £162 per week and £892 per week) and 2% (over £892 per week).

Pension Contributions

Provided you can wait for the money, pension contributions are an extremely tax efficient way of taking profit out of the company. For the Company, any contribution is a valid business expense, saving Corporation Tax at 19% and doesn't incur any employer National Insurance Contributions.

For the individual Director, there are no National Insurance Contributions and Income Tax is deferred. This means you pay no income tax when the contributions is made, only when you take the money out in retirement. This allows a substantial Income Tax saving if you avoid paying tax at 40% / 45% in the year of the contribution and are careful in how you withdraw it on retirement. The main disadvantage is that your money is locked away until you're 55.

Interest on Director Loans

If you've invested money in the business, you can be paid interest on the amount you've lent, provided the interest rate is commercially justified. From the company's perspective this is a valid business expense, with no National Insurance Contributions, saving tax at 19%.

For the individual Director there are no National Insurance Contributions to make. Income Tax is paid at the same rates as for Salaries and Bonuses, but there's a personal savings allowance of £1,000 (for Basic Rate taxpayers) or £500 (for Higher Rate taxpayers) in which you pay no income tax.

Rent on assets

It's usually best to hold assets likely to increase in value outside of your company. This is because the company pays Corporation Tax on any capital gains on such assets, but they also increase the value of the business meaning that owners pay Capital Gains Tax on selling shares. This "double taxation" is avoided by keeping the assets outside the business.

From a profit extraction perspective it allows you to transfer profit out of the business via lease payments (provided these are commercially reasonable). From an Income Tax perspective these payments are similar to Salary and Bonus payments - a valid business expense saving Corporation Tax at 19%, with Income Tax payable by the Director at 20%, 40% or 45%. However compared to Salary / Bonus payments there are no National Insurance Contributions.

Personal Allowance

Most individuals are entitled to an annual personal allowance on their Income Tax. For people earning under £100,000 the allowance is £11,850, reducing by £1 for every £2 above this (so those earning above £123,700 have no allowance).

The personal allowance is relevant to your profit extraction because you can choose which income source it applies to. Income tax rates are applied first to non savings income, then savings income, then dividend income. This means that after applying your £2,000 annual allowance, dividends may immediately start being taxed at 32.5% or 38.1%. By allocating your personal allowance against your dividend income you pay more tax in the basic rate band on other sources (charged at 20%) but save tax on dividends at 32.5% or 38.1%.

Optimisation Strategies

There's no "one size fits all" strategy - tax planning needs to take into account your individual tax circumstances and other financial affairs. But the following general strategies are usually helpful:

Limiting Salary / Bonus payments

It's usually best to only draw a small salary for your work as a Director. If this is limited to £8,424 then neither the Company nor the Director has to make any National Insurance Contributions, while still enjoying all of the benefits (such as qualifying for a year's contribution towards your state pension).

Maximising use of interest payments

Charging a commercially reasonable interest rate on any amounts you've invested in the business, and a reasonable rent on any property or other assets owned personally but used in the business. Compared to salary these payments have no National Insurance Contributions, while still saving Corporation Tax.

Maximising pension contributions

If appropriate to your overall financial circumstances, making pension contributions is a very tax efficient way of taking profit from the business. Keep in mind however that this money can't be accessed until you're at least 55.

Optimising use of personal allowance

Where your overall income levels mean you're paying tax on dividends above 7.5%, allocate any available personal allowance against the amount being taxed above 7.5%.