Directors of family companies are regularly faced with the key issues of extracting profits in the most tax efficient way but at the same time wishing to ensure that undue strain is not placed on the operational liquidity position of the business.
The two main methods of extracting profits are via a salary and/or dividends with a combination of both normally recommended as the being the most appropriate and tax effective.
Before looking at some practical situations it is useful to consider the main features of both salaries and dividends:
Salary
- Salary payments, over certain limits, are liable to both income tax and National Insurance Contributions (NIC) under the PAYE system.
- Unlike a dividend, a salary can be paid even where a company is loss-making.
- For 2013/14 the first £9,440 of gross salary is exempt from income tax in the form of a personal allowance (£10,000 for 2014/15).
- For directors, employees NIC is only payable where the gross salary for 2013/14 exceeds £7,755 (£7,956 for 2014/15).
- The combined cost of the gross salary plus any employer Class 1 NIC (where salary exceeds £7,696) is treated as a ‘payroll cost’ and therefore tax deductible for corporation tax.
- From April 2014 a new NIC Employment Allowance is being introduced whereby the first £2,000 of employer NIC is exempt. A comprehensive article covering this initiative can be accessed on our website via the following link:
Dividends
- Dividends are treated as an appropriation of profits and therefore are not deductible for corporation tax and need to be paid out of post-tax profits.
- Dividends are not liable to NIC by the shareholder or the company.
- Dividends come with a non-repayable 10% tax credit and are liable at special income tax rates. Overall, this can result in significant tax savings.
- Dividends can only be declared or paid where the company has sufficient current profits or undistributed reserves from previous accounting periods.
- Unlike salaries, dividends must normally be paid at the same rate to all shareholders holding the same class of shares.
- Dividends can be paid more than once a year and can be paid quarterly or even monthly where desired.
- It is vital to follow certain procedures when paying a dividend to ensure that it is properly declared and documented.
A Tax Efficient Combination
- Paying an annual salary capped at £7,696 (for 2013/14) ensures that no NIC is payable by either the director or the company but still creates a track record of NIC credits towards state pension and certain other state benefits. The balance of funds required can then be extracted tax-efficiently via dividends.
- The following table provides a comparison of the total amount of tax & NIC payable at various profit levels of extracting profits wholly by salary or via a combination of salary and dividend together with the potential savings. Note that the figures take into account any corporation tax payable. All figures are to the nearest £100.
|
Company Profits |
All Salary |
Salary & Dividends |
Tax & NIC Saving |
|
£25,000 |
6,600 |
3,500 |
£ 3,100 |
|
£50,000 |
17,000 |
9,300 |
£ 7,700 |
|
£100,000 |
41,500 |
29,300 |
£ 12,200 |
|
£150,000 |
69,800 |
53,000 |
£ 16,800 |
Avoiding Higher Rate Income Tax
- One of the key benefits of paying dividends is that the rate of income tax is effectively NIL% where the taxpayer’s income does not exceed the basic rate limit.
- Therefore where an individual director/shareholder wishes to eliminate any higher rate income tax the following strategy could be adopted:
Example
Assume that a company with £50,000 post-tax profits is owned by a single shareholder/director who wishes to avoid paying any higher rate income tax.
Given that for the 2013/14 tax year the shareholder is entitled to a personal allowance of £9,440 and a basic rate band of £32,010, it is therefore possible to have gross taxable income of £41,450 without incurring any higher rates of income tax.
Taking into account an attached 10% tax credit a cash dividend of £37,305 (i.e. 90% x £41,450) should be paid to achieve the optimum tax-free position.
Should the shareholder also wish to withdraw a small salary of (say) £7,696 then this will of course reduce the amount of dividend to avoid higher rate tax.
The amount of dividend then becomes: 41,450 – 7,696 = 33,754 x 90% = £30,379.
This would result in tax-free spendable income of £38,075 (30,379 + 7,696) i.e. £770 more than a dividend only approach.
Beware Dividend Waivers!
Following a recent decision in favour of HM Revenue & Customs (Mr P McLaren v HMRC 2014), shareholders should beware of waiving dividends with a view to increasing the amount payable to a shareholder spouse. Where such action follows a gift of shares to a spouse it may well result in the income waived being taxable back on the spouse who has made the dividend waiver.
Retention of Profits
In practice it is not normally either feasible or desirable to extract all of the company’ profits as this can obviously have an adverse affect on the liquidity and working capital position of the business. Where some profits are retained within the company then this should result over time in an increase in the value of the shares on a subsequent sale of the company. Subject to meeting certain conditions, the present capital gains tax regime taxes such gains at a special entrepreneurs’ rate of 10% rather than the normal CGT rates of 18% and/or 28%.
Further Advice
If you require further advice on the extraction of profits from your company then please call us on 01633 215544 or email us at: contact@marshvision.com
Readers who are considering a business start-up in the near future or who currently operate an unincorporated business are recommended to read our ‘Benefits of Incorporation’ article via the following link:
http://www.marshvision.com/LG-Tax-Benefits-of-Incorporation-2013.asp
