One of the key issues for any business owner is, ‘How do I get money out of my business tax efficiently?’.
If you are a ‘sole trader’ or a ‘partner’ in a business (Old style Partnership or a Limited Liability Partnership –LLP) this is pretty straight forward, in that you are taxed on your share of the profits of the business, regardless of how much you take out of it. If the business makes £100k profit, but you leave it all in the business, you will still be taxed on £100k. The tax efficiency comes from making sure you claim all the tax allowances possible in calculating the profits of the business.
So the only real limitation in this situation is the amount of cash you can afford to extract. Obviously, common sense says that over a reasonable period of time you shouldn’t take out more than the business makes in profit and can reasonable afford, but the amount you take out to spend personally has no impact on the tax you pay.
For those running a limited company (or group of them) the situation is different. The business will pay corporation tax on the profit it reports, but the individuals will also pay tax based on what they take from the business. The more they withdraw, the higher their personal tax bills. Again, common sense means that over a period of time you shouldn’t take more than the business can reasonably afford to pay you, but if you have a bad year and make no profits, but still take out income (spending some of previous year’s profits) then you will still have personal tax to pay.
In the vast majority of cases a limited company structure will give the best balance of risk protection and flexibility that business owners want, and a more manageable tax position, so we will focus this note on the tax impact for company shareholder/directors.
So the key point to understand is that these director/shareholders pay tax on the income they take from the business. This can be via a number of options, the most common being…
- Salary or bonuses. In this case the payments will be processed through normal payroll systems, and tax and National Insurance (EE’s and ER’s) paid as it is taken. The net income is then passed to the individual.
- This represents a return to shareholders of profits made in the current and previous years. The amount is paid directly to the shareholder, and added to their self-assessment tax return with tax usually paid in two lumps in January and July each year.
- Benefits in Kind. Some business owners opt to run their cars through the company, or to pay for private medical insurance or other ‘perks’ they choose to have. An annual tax form declares these amounts (P11d) and tax is assessed on the self-assessment tax returns as above.
There are further complications to consider. Salary or bonuses are taxed at source under the PAYE rules, so the cash impact of the tax is almost immediate. The upside of this ‘Pay as you go’ approach is that there is less of a nasty surprise when your annual tax is calculated, as you will have paid most of it already. Whilst this type of payment also comes with the extra burden of EE’s and ER’s national insurance contributions, the whole amount is a deduction from profit when you work out the company’s corporation tax bill.
By contrast, dividends are paid out of the profits after tax has been calculated (so they are not tax deductible) but doesn’t have any EE’s and ER’s NIC added. The person receiving the dividend declares it on the next tax return and pays the tax long after the amount has been received. A great cash flow advantage, but in our experience it is very common for the full dividend to have been spent before the tax bill comes, and this can be a painful point for many director/shareholders!
So which is better?
Let’s suppose it is a company with one director/shareholder. They probably don’t really mind whether the tax bill is a bigger corporation tax bill and a smaller personal tax one, or vice versa, or whether it is paid as tax or as NIC. They are probably just interested in the smallest amount of money going to HMRC overall, to deliver them the net income they want. So what is the right blend?
The difficulty with giving a clear cut answer is that the tax rates on company profits will soon go up and be at different rates depending on profit levels. Income tax rates and NIC rates vary depending on the amount of income taken, and even personal tax allowances can be reduced depending on the level of income in any tax year.
However, in very broad terms, salary is marginally less tax efficient when company tax rates are 19%, and marginally better when they become 25% (in 2023/24 tax year for profits over £250k).
If the business is a bit more complex, it may have multiple shareholders with different shareholdings, that mean the decision on what dividends to pay a much more complicated equation, as each shareholder should only receive their ‘share’ of dividends based on the number of shares they hold.
Let’s also mention briefly the tax on benefits in kind. If you have perks provided by the business, then these are also taxed on what HMRC decides is the value of the perks, and added to your self-assessment tax calculation. Whilst private medical insurance that costs say £1,000 is taxed at that level, the tax rate on a company car varies with the make and model, and whether it is electric or not. We could not possibly cover all of the variables for company car tax in this short note!
(By the way, it also seems particularly unfair to compare the ‘perk’ of providing a luxury car for a company director with a middle range family car used by a sales person clocking up 50,000 business miles, how is that a ‘perk’!)
So what should you do in your business?
Honestly, we don’t know. The answer will be a completely unique blend of the various ways of extracting money, that varies based on the business profit levels, your earnings, and the cash flow impact of one option over another. Add into the mix the tax efficiency of making pension contributions as part of the package (but with the downside of locking the money away for the future) and no two clients will have the same answer.
The solution is to undertake a remuneration planning review that considers all of these options (and more) to tailor the perfect blend for each individual. There is no point telling you after the event that you could have saved tax by doing something different, so you should be looking at this now for the 2023/24 tax year that starts on 6 April 2023. It’s not far away!
So if you are not sure if your tax advisor is guiding you on the right solution for you, give us a call.
Your Tax Partners