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How best to extract profits from your business

Author Image The Technical Team
14 minutes read
Last updated on 6th Apr 2018

Overview

Discover the three main ways to extract profits from a limited company and how these can be used to improve your client’s financial situation. 

Key points

  • Taking excess (non-required) income from a Ltd company year on year could be better placed in a pension.
  • The methodology to calculate the taxation applies not only to individuals salary but also Ltd Company Profits.
  • Dividends can “beat” salary to meet immediate daily needs

Three routes to extract profits

There are three main routes for a business owner to extract profits from their own Ltd company: salary, dividends and pension contributions (although this is taking money from the company for future use). The other alternative is to leave the profit in your company and take the proceeds from the subsequent sale.

The key determination on this is the net benefit to the owner in terms of how they structure their payments. Whilst no one likes making payments in tax or national insurance, if you could do this in a way that gives you the most benefit why would you not? Paying tax is not a bad thing if the end result is more money in your pocket, at the time you need it.

The simplest example on net benefit is a basic rate taxpayer making a pension contribution. If they are basic rate taxpayers at the time of taking the benefit they have effectively turned an £80 net contribution into an £85 net benefit (tax relief on the £80, will make this £100 into the pension, 25% can be taken tax free and the remaining 75% is taxed at 20%). Knowing this, would you prefer to have 100% of the £80 and keep this in your bank account, or would you rather make a pension contribution and get 85% of £100, at some point in the future?

Whilst the above is a simple equation for an employed person with no access to a salary sacrifice or net pay arrangement, for the owner/operator of a limited company there are several factors to take into account.

Taxation that will apply to a business owner when taking profit

In order to understand the impacts of the various methods, I have detailed how profits can be taken from a business, how they are taxed and the effective rates of taxation that are applied. This may help generate the conversation with SME business owners. 

Business

Corporation Tax

Corporation tax is simply a tax on the profits of an incorporated business i.e. an LTD or a PLC. The rate was cut from 20% to 19% in 2017 and will be cut further to 17% in 2020.

You can deduct the costs of running your business before your profits are calculated, so employee payments (including to the business owner where they are also an employee), employers National Insurance and pension contributions (subject to the wholly and exclusively rule) are allowable deductions, inter alia.

Employers National Insurance

Employers have to pay national insurance for their employees once their salary reaches certain thresholds. The rates that are paid can vary depending on an employee’s age (the Upper Secondary Threshold introduced from April 2015 for employees under the age of 21), status, and if they are in a contacted out scheme or not.

As most owner operators will not qualify for any differing rates we will work on the assumption of the below rates for employers NI rates (monthly rates have been rounded): 

Category letter

£0 to £162 a week (£0 to £702 a month)

£162.01 to £892 a week (£702 to £3,863 a month)

Over £892.01 a week (£3,863.01 a month)

A

0%

13.8%

13.8%

Therefore, from an employer point of view, any employee earnings over £8,424 will attract a NI payment of 13.8%.

Find more details of the National Insurance rate and categories.

 

Individual

Salary

This will be taxed as per any employee, you will have a personal allowance which is £11,850 per annum in 2018/19. Remember there is a reduction for those with adjusted net income over £100,000.

After the personal allowance is exhausted earned income is taxed at three main rates, this is now dependant on if an individual is liable to the Scottish Rate of Income Tax (SRIT), further information on this can be found on our article Income tax rates and order of tax.

 

  Non SRIT SRIT
  Rate Band Rate Band
Starter Rate N/a N/a
19% £0 to £2,000
Basic Rate 20% £0 to £34,500 20% £2,000 to £12,150
Intermediate Rate N/a N/a 21% £12,150 to £31,580
Higher Rate 40% £34,500 to £150,000 41% £31,580 to £150,000
Additional Rate* 45% Over £150,000 46% Over £150,000

*Please note, additional rate tax has now been renamed Top Rate in Scotland.

Find out more in our article on the personal allowance. For details on taxation, including the Scottish Rate of Income Tax, see our article on Income tax rates and order of tax.  

Employees National Insurance

Much like the employer contributions above, the rates and amounts of employee NI contributions can vary, but for most employees they will fall into the following bandings.

Category letter

£0 to £162 a week (£0 to £702 a month)

£162.01 to £892 a week (£702.01 to £3,863 a month)

Over £866.01 a week (£3,863 a month)

A

0%

12%

2%

Dividends Received

Dividends are payments from company profits to shareholders.

Dividends from companies, unit trusts and open-ended investment companies are all taxed in the same way.

From 2016/17, dividend taxation as we knew it changed. The dividend tax credit was removed and was replaced by the system detailed below.

There is now a Dividend nil rate of taxation applied to the first £2,000 per annum (this reduced on 6 April 2018 from the previous £5,000 level). Thereafter dividends will be taxed as below:

Basic Rate   7.5%

Higher Rate   32.5%

Additional Rate   38.1%

It’s important to understand that the 0% is a starting rate of tax on the dividend and not a deduction on the amount of dividend received. For example, if an individual has fully used their personal allowance, is £1,000 below the higher rate threshold and receives £3,000 of dividends, £1,000 of the dividends would be taxable at the higher rate for dividends.

Note: it’s the whole of the dividend payment that is included in the tax computation and not just the balance above £2,000. Although the first £2,000 is 0% rated, any balance will be taxed in the tax band in which it falls. Dividends can be set against any unused Personal Allowance before application of the £2,000 allowance. So effectively a person with no income can receive £13,850 in dividends before tax becomes payable.

The table below will show this in practice:  

Dividend Tax Allowance

 

So how can you get the profits out of your business in the most tax efficient manner?

The simple answer to this is to make pension contributions. As detailed above these do not suffer corporation tax or NI when these are made from the business, and when the benefits are taken 25% is tax free and thereafter taxed at marginal rates with no NI to pay.

Whilst the most tax efficient, perhaps not the most practical solution!

Those under 55 need an accessible source of income for living expenses.

Those over 55 could in principle use immediate vesting pension contributions to provide their living expenses but in reality that’s not likely (the recycling rules could come into play) - is it worth the bother of the practicalities of paying and vesting a pension every year?  Notwithstanding the aforementioned, accessing pensions in excess of any tax free cash triggers the MPAA hampering the ability to fund your pension in excess of £4,000. For more information, see our article on the Money Purchase Annual Allowance.

In any event, given the generosity of tax treatment should you not be using your pension to fund your needs in retirement as opposed to your immediate needs?  

So, we need to look at how can a client extract money from their business to meet day-to-day living costs both now and in the future. The table below shows a basic comparison between the three remuneration methods for the 2018/19 tax year, where £1,000 of payment falls wholly in the relevant tax or NI band and 25% tax free cash is taken:

 

 

Corporation Tax

Employer National Insurance

Employee National Insurance

Income Tax (assuming 25% tax free cash)

Dividend Tax

Per £1,000 of business profit in your pocket

Percentage rate of taxation on the £1,000

Basic rate

Salary

0.00%

13.80%

12.00%

20.00%

0.00%

£597.54

40.25%

Dividend

19.00%

0.00%

0.00%

0.00%

7.50%

£749.25

25.08%

Pension contribution

0.00%

0.00%

0.00%

15.00%

0.00%

£850.00

15.00%

Higher rate

Salary

0.00%

13.80%

2.00%

40.00%

0.00%

£509.67

49.03%

Dividend

19.00%

0.00%

0.00%

0.00%

32.50%

£546.75

45.33%

Pension contribution

0.00%

0.00%

0.00%

30.00%

0.00%

£700.00

30.00%

Additional rate

Salary

0.00%

13.80%

2.00%

45.00%

0.00%

£465.73

53.43%

Dividend

19.00%

0.00%

0.00%

0.00%

38.10%

£501.39

49.86%

Pension contribution

0.00%

0.00%

0.00%

33.75%

0.00%

£662.50

33.75%

SRIT

 

 

Corporation Tax

Employer National Insurance

Employee National Insurance

Income Tax (assuming 25% tax free cash)

Dividend Tax

Per £1,000 of business profit in your pocket

Percentage rate of taxation on the £1,000

Starter Salary 0.00% 13.80% 12.00% 19.00% 0.00% £606.33 39.37%
Dividend 19.00% 0.00% 0.00% 0.00% 7.50% £749.25 25.08%
Pension contribution 0.00% 0.00% 0.00% 14.25% 0.00% £857.50 14.25%

Basic

Salary

0.00%

13.80%

12.00%

20.00%

0.00%

£597.54

40.25%

Dividend

19.00%

0.00%

0.00%

0.00%

7.50%

£749.25

25.08%

Pension contribution

0.00%

0.00%

0.00%

15.00%

0.00%

£850.00

15.00%

Intermediate

Salary

0.00%

13.80%

12.00%

21.00%

0.00%

£588.76

41.12%

Dividend

19.00%

0.00%

0.00%

0.00%

7.50%

£749.25

25.08%

Pension contribution

0.00%

0.00%

0.00%

15.75%

0.00%

£842.50

15.75%

Higher (below rUK)
(£43,430 - £46,350)

Salary

0.00%

13.80%

12.00%

41.00%

0.00%

£413.01

58.70%

Dividend

19.00%

0.00%

0.00%

0.00%

7.50%

£749.25

25.08%

Pension contribution

0.00%

0.00%

0.00%

30.75%

0.00%

£692.50

30.75%

Higher (above rUK) Salary 0.00% 13.80% 2.00% 41.00% 0.00% £500.88 49.91%
Dividend 19.00% 0.00% 0.00% 0.00% 32.50% £546.75
45.33%
Pension contribution 0.00% 0.00% 0.00% 30.75% 0.00% £692.50 30.75%
Top Salary 0.00% 13.80% 2.00% 46.00% 0.00% £456.94 54.31%
Dividend 19.00% 0.00% 0.00% 0.00% 38.10% £501.39 49.86%
Pension contribution 0.00% 0.00% 0.00% 34.50% 0.00% £655.00 34.50%

The higher rate for SRIT has been split owing to the differential for NI rates in the higher rate SRIT band. For rUK NI moves to 2% annually at £46,350 which matches the rUK higher rate of tax. This creates a differential in the effective rate of taxation as detailed.

Note – in the tables above the £1,000 is the business profit available for remuneration. As such to be paid as salary the employer must retain some of the profit to pay the employers NI so to achieve this only £878.73 can be paid as salary as £121.27 employers NI is due on this amount. The employee NI of 12% is due on this £878.73 (£105.45). So overall £226.72 is deducted in NI from the employer’s profit (22.67%).

Using the above example, once basic rate income tax and employee National Insurance is taken from the £878.73 only £597.54 is received in the individual’s bank account. So effectively this is an overall rate of taxation of 40.25%.

As can be seen, based on the above and assuming that all available allowances have been used, then dividends “beat” salary to meet immediate daily needs.

But the interaction between allowances and NI thresholds can greatly affect this, for instance you can take a salary up to the personal allowance without paying income tax, but there would be employees and employers NI payable from £8,424.

When planning for the business owner should the aim be to minimise payments to HMRC and retain as much as possible for the owner? Ultimately the business owner has to extract enough profit to live on so, where is the “sweet spot” for taking a combination of salary and dividends?

Is the answer taking a salary of £8,424, with the remainder as dividends? Perhaps. Given the nuances of the rates of taxation, thresholds and allowances, is the answer it depends? 

Salary

Rationale

£0 to £8,424

Any salary paid as this level has no income tax, employee or employer NI to be paid (these are all corporation tax deductible). Whereas dividends will not have a personal tax liability, but will have had corporation tax of 19% deducted first. Therefore salary wins here.

£8,424 to £11,850

Salary will again have no income tax deducted, but employees and employers NI will be deducted at an effective rate of 22.67%. Dividends again suffer 19% corporation tax. So dividends win here

£11,850 to £13,850

Salary at this level will be liable to income tax, employees and employers NI, an effective rate of 40.25% (39.37% for SRIT). As the dividends so far used the unused personal allowance the £2,000 zero rate can be used in this range of remuneration. These are again taxed at 19% corporation tax and no individual liability exists. So dividends win again. 

Beyond £13,850, it is safe to assume that all available allowances have been used, and as can be seen, dividends are the way to extract the monies for immediate expenses.

Should any unused profit left after satisfying the immediate income need and not needed by the business, be used to make pension contributions?

Unlike individual contributions, employer contributions are paid before deduction of both NI contributions and Corporation tax.  This means 100% of the profit is available to the business owner in future, only being subject to marginal rate income tax on 75% of the pension fund. Or, in other words, effective tax rates of 0%, 15%, 30% and 33.75% (or 14.25%, 15%, 15.75%, 30.75% or 34.5% for Scotland), depending on tax status in retirement. Given all the taxes for the company and the individual these are likely to be lower.

Why put the money away for the future if you are happy paying the dividend tax?

 

 

Some business owners would rather take the money out and have this in their current account so that they have total control on this – presumably they believe they don’t control their pensions?

But if they saw the following example of how this would work for 2018/19, would they still have the same opinion?

John (who is not a SRIT taxpayer) has a business and is taking profits from this in the form of dividends, he is a higher rate tax payer and is taking £1,000 net more than he needs each month to put in his bank account. Even if he could be convinced to give up £500 a month of this and put this into a pension then his situation would be greatly altered.

£500 a month equates to £6,000 per annum, grossing this back up with the higher rate of dividend taxation applied (32.5%) this means that the business needed to pay £8,888.89 gross for this to go to John.

But the above dividend payments can only be made after the business has paid corporation tax, so the total profits from the business needed to provide this dividend becomes £10,973.94.

Paying this £10,973.94 from the business to a pension would avoid immediate taxation (corporation tax and dividend tax in this case).

The Centre for Policy Studies research has estimated that 6 out of 7 higher rate taxpayers are not higher rate taxpayers in retirement. So assuming that John is a basic rate taxpayer in retirement, this would give him £9,327.85 (as per the benefit per £1,000 in the table above).

If you asked John if he is willing to give up £6,000 a year in his current account that he presently does not need and instead have £9,327.85 in his bank account when he is retired, what would he say?  He can’t say we’ll invest that money to get a better overall return, as most investments will be available in the pension.

 

 

But what about Entrepreneurs' Relief, would it not be more efficient to leave the money in the business and benefit from this on sale of the company?

Entrepreneurs' Relief is only chargeable at 10%. As such it would appear that this would be the most efficient way to extract the profit from the business (should the business qualify for this), as any profits left in the business when it is sold will only be taxed at 10%. So would that be cheaper?

It’s important to remember that the profits retained by the business will have already been subject to corporation tax.

Therefore, all things being equal the retained profit is “capital gain” and the Entrepreneurs' Relief effectively applies 10% taxation to 81% of each year’s profit. So the effective rate of taxation is 27.1%, or to compare this to the above table per £1,000 in the business you will receive £729 back.

As can be seen from the above table, if the business owner is likely to be a basic rate taxpayer in retirement, then pension contributions clearly win. For a higher rate taxpayer this results in a marginally higher rate of tax on the pension (30%), against 27.1% tax using Entrepreneurs' Relief. For an additional rate taxpayer in retirement this would appear to make no sense.

However, pensions have another distinct advantage. Many people see their business as their pension but having your business as your pension has many downsides, it is available to creditors, it may not be sellable at the right time etc. etc. etc. In fact do any of your other clients have all their retirement funds riding on an investment in a single private equity? I’d suggest the answer to that is no.

So why let your business owner defy conventional planning logic?   Having a pension and a business to fund your retirement helps diversify risk, make retirement more flexible with more options than having “business only”. A plan B guarding against a failure of Plan A. For a higher rate taxpayer in retirement would they rather pay an extra 2.9% for that peace of mind or to have a plan B?

Taxation on death

Pensions are usually free of IHT on death and the taxation of the death benefits now normally remains around where the member was aged under 75 at time of death. Pre 75 the benefits are free of tax when these are paid to an individual, post 75 death are taxed at the marginal rates of taxation when these are paid to an individual. Further information on this can be found in our Death benefits - defined benefits schemes article, Annuity death benefits article and Defined contribution schemes and death benefits article.

Where the business owner dies when the business still has value, the Inheritance Tax Act 1984 provides relief for certain types of business or business property included in either a lifetime transfer or the deceased’s death estate. This may give 100%, or 50% depending on the nature of the company. Further information on this can be found in our article on Business Property Relief: the facts. It is important to note the section on Excepted Assets (including ‘surplus cash’), as any excess cash not required for the purposes of the business may not get any IHT exemptions.

Conclusion

As can be seen there are a limited amount of options for extracting company profits.

Each of these has their own particular tax and national insurance consequence for the business owner with their employer and employee "hats" on. 

Whilst this can be technically complex is the planning not simple?

You extract the minimum amount of profit required to fill your current account for immediate needs and the rest goes into your pension to maximise your current account of the future.  Unless you can invest to make your current account bigger than what your “future current account” would be…

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