For small owner-managed businesses in the UK, the method of drawing profits from a limited company can significantly impact the overall tax liability. With careful planning and a good understanding of the available options, business owners can maximise their post-tax income.
Laura Mainwaring, our local Accountant in St Albans, has put together this informative article to explore the most tax-efficient ways of extracting profits, covering dividends, salaries, bonuses, pensions, and other strategic methods.
Dividends
Dividends are often the preferred method for many small business owners to extract profits due to their favourable tax treatment compared to salaries. Here’s a detailed look at why dividends are tax-efficient:
How Dividends Work
Dividends are payments made to shareholders from the limited company’s profits after corporation tax. The amount available for distribution depends on the company’s retained earnings and is declared by the company's directors.
Tax Treatment
- No National Insurance Contributions (NICs): Unlike salaries, dividends do not attract NICs, which can result in significant savings.
- Dividend Allowance: The first £500 of dividend income is tax-free.
- Tax Rates: Dividends are taxed at lower rates compared to salaries. For the 2024/25 tax year, the rates are:
- Basic rate: 8.75%
- Higher rate: 33.75%
- Additional rate: 39.35%
Strategic Considerations
To maximise tax efficiency, it’s common for business owners to pay themselves a small salary up to the personal allowance threshold (£12,570 for 2024/25) and then take the remainder of their income as dividends. This strategy optimises the use of personal allowances and reduces NICs.
Salaries
While dividends are tax-efficient, salaries still play an essential role, especially when considering certain allowances and pension contributions.
How Salaries Work
Salaries are regular payments made to employees (including directors) for their work. They are subject to Income Tax and NICs.
Tax Treatment
- Personal Allowance: The first £12,570 of salary is tax-free (2024/25).
- NICs: Salaries attract both employer and employee NICs. The rates for employees are 8% for earnings between £12,570 and £50,270, and 2% for earnings above £50,270. Employers pay 13.8% on earnings above £9,100.
- Deductible Expense: Salaries are deductible expenses for the company, reducing the corporation tax liability.
Strategic Considerations
Paying a salary just up to the NIC threshold ensures that the individual is credited with National Insurance contributions, which counts towards state pension and benefits, without incurring NIC costs. Combining a minimal salary with dividends can balance tax efficiency and personal financial planning.
Bonuses
Bonuses can be an attractive option for drawing profits, particularly when aiming to reward specific achievements or when profits exceed initial expectations.
How Bonuses Work
Bonuses are typically paid in addition to regular salaries and are subject to the same tax and NICs as salaries.
Tax Treatment
- Income Tax and NICs: Bonuses are treated as earnings and therefore subject to Income Tax and both employer and employee NICs.
- Deductible Expense: Bonuses are deductible for corporation tax purposes, reducing the company’s taxable profits.
Strategic Considerations
Timing bonuses can be crucial, so gain the knowledge from your local accountant. If profits are high and corporation tax needs to be reduced, paying a bonus can achieve this while rewarding employees. However, the overall tax and NIC implications need to be carefully evaluated.
Pension Contributions
Employer pension contributions can be a highly tax-efficient way of extracting profits, benefiting both the individual and the company.
How Pension Contributions Work
The limited company makes contributions to a registered pension scheme on behalf of the director or employee.
Tax Treatment
- Tax Relief: Employer contributions are deductible expenses for the company, reducing corporation tax liability.
- No NICs: Pension contributions are not subject to NICs.
- Annual Allowance: Contributions up to £60,000 per year can benefit from tax relief, with unused allowance from the previous three years potentially available for carry forward.
Strategic Considerations
Pension contributions can significantly boost retirement savings and reduce immediate tax liabilities. However, funds are generally not accessible until the individual is 55, so this strategy requires a balance between current income needs and long-term planning.
Directors' Loans
Directors’ loans offer another method for extracting profits, albeit with specific rules and potential tax implications.
How Directors' Loans Work
A director can borrow money from the company, but this must be repaid within nine months of the company’s year-end to avoid tax penalties.
Tax Treatment
- Benefit in Kind: If the loan exceeds £10,000 at any time, it is treated as a benefit in kind, and interest must be paid at the HMRC official rate.
- Corporation Tax: If the loan is not repaid within nine months of the year-end, the company must pay a 32.5% tax charge, which is refundable when the loan is repaid.
- Income Tax: Any write-off of the loan is treated as income and taxed accordingly.
Strategic Considerations
Directors’ loans can provide short-term cash flow solutions but must be managed carefully to avoid adverse tax implications. Regular repayments and maintaining thorough records are essential. Always seek advice from your accountant, they will structure Director’s Loans to avoid against tax penalties.
Rent for Use of Home Office
If a director or employee uses their home for business purposes, charging rent to the company can be another tax-efficient way to extract profits.
How Rent for Home Office Works
The limited company pays rent to the director for using part of their home as an office, which must be reasonable and justifiable.
Tax Treatment
- Deductible Expense: Rent paid is a deductible expense for the company.
- Income Tax: The director must declare the rental income, but allowable expenses (e.g., a proportion of mortgage interest, utilities) can offset this.
- No NICs: Rental income is not subject to NICs.
Strategic Considerations
To avoid issues with HMRC, it’s crucial to document the arrangement and ensure the rent charged reflects the market value and actual usage.
Profit Extraction through Capital Gains
Selling shares in the limited company can sometimes provide a tax-efficient way to extract profits, benefiting from capital gains tax treatment.
How Capital Gains Work
When a shareholder sells shares in their company, the gain (difference between sale price and purchase price) is subject to Capital Gains Tax (CGT).
Tax Treatment
- Annual Exemption: The first £3,000 of capital gains is tax-free (2024/25).
- CGT Rates: For basic rate taxpayers, CGT is 10% on gains from business assets, and for higher rate taxpayers, it is 20%.
- Business Asset Disposal Relief: Qualifying disposals may benefit from a reduced CGT rate of 10% on gains up to £1 million (as a lifetime allowance).
Strategic Considerations
Planning share disposals to utilise annual exemptions and reliefs can significantly reduce tax liabilities. It’s advisable to seek professional advice from your accountant to ensure compliance and optimise tax efficiency.
Conclusion
For small owner-managed businesses in the UK, understanding and strategically utilising the various methods of drawing profits from a limited company can result in significant tax savings. While dividends often stand out as the most tax-efficient method, combining different strategies like salaries, bonuses, pension contributions, directors’ loans, rent for home office use, and capital gains can create a balanced and tax-optimised approach.
Each business’s circumstances are unique, so it’s crucial to tailor these strategies to individual needs and seek professional limited company advice to navigate the complexities of tax legislation. By doing so, business owners can ensure they maximise their take-home profits while maintaining compliance with UK tax laws.
So, talk to your local Accountant in St Albans for up-to-date advice on legislation, tax strategies and planning and incorporation advice for limited company start-ups.