Company owners wishing to extract profits from their companies as tax efficiently as possible face an array of conflicting and ever-changing factors.
When companies make profits, there are a number of available methods for extracting funds:
- Remuneration for employees/directors (salary, bonuses, benefits etc.);
- Distribute profits to their shareholders by way of dividends;
- Company pension contribution;
- Payment of rent (where the property is rented by a director/shareholder);
- Interest (where loans have been made to the company);
- Capital distribution; and
- Private Investment Schemes.
This is a summary of the various methods in which profits can be extracted from a company by its shareholders and employees, and the tax implication of each of them.
The most obvious way to move profit from the company to yourself is by paying yourself a salary. Since you do not pay any tax on the first £12,500 of income, you will pay 20% income tax on any salary you take that is between £12,500 and £50,000. If you go over that threshold, your income tax liability shifts to 40% on earnings above the threshold.
If you are a director you can pay yourself a salary at a level of £8,632 per year (£719 per month) for 2019/20 and still be able to enjoy the benefit of state pension entitlement without National Insurance Contributions (NIC) being payable. Where remuneration is paid in cash form (such as a salary, bonus payment), the employee is liable to income tax, as explained above, and Class 1 NICs if the salary is over the threshold of £8,632 (12% and/or 2%), unless the taxpayer is not liable to NIC e.g. due to being over the State Pension age. The employer company will also be liable for secondary Class 1 NICs (13.8%) on the remuneration paid above the threshold. Tax and NIC must be deducted at source by the company under PAYE. The salary and any secondary Class 1 NIC liability is also deductible for corporation tax purposes.
Care needs to be taken when there is an optional remuneration arrangement (i.e. salary sacrifice arrangement or flexible benefit arrangement) entered into on or after 6 April 2017, where the taxable benefit will be treated as higher of:
- The amount of salary forgone (less any amounts made good by the employee); and
- The cash equivalent of the benefit in kind (for example car, cash allowance etc.)
Due to the availability of the £3,000 employment allowance against NIC liabilities, it will be beneficial for directors of companies with two directors (e.g. husband and wife) to pay themselves a core salary of £12,500 each (i.e. up to the level of the personal allowance, providing they do not have other taxable income) where the employment allowance would otherwise not be used.
Companies typically distribute their profits to shareholders by way of dividends. Dividends are chargeable to income tax. However, dividends are not earnings for NIC purposes (unless they are deemed to be a salary) so dividend payments are not subject to NIC.
This is the case even if the shareholder is also an employee or director of the company. Dividends can be paid at any time as long as the company has sufficient distributable profits.
The rates of income tax for the 2019/20 tax year are as follows:
|Dividend allowance (£2,000)||0%|
|Basic rate band||7.5%|
|Higher rate band||32.5%|
|Additional rate band||38.1%|
There is no tax on the dividend income which is covered by the remaining personal allowance nor on the dividend income within the dividend allowance of £2,000.
It will usually be more efficient from the individual’s perspective to extract funds by way of a dividend rather than by salary or bonus given the higher rate of tax on remuneration. The dividend route also removes the employer from an obligation to pay 13.8% secondary NICs.
However, dividends are not deductible for corporation tax purposes and dividends are not treated as earnings for pension purposes (although the shareholder could still make gross pension contributions of £3,600 gross per annum and obtain tax relief on such contribution where they have no ‘relevant earnings’ in any event).
This is a more attractive option than the simple remuneration route unless the director/employee is exempt from paying the NIC contributions.
Pension contribution is the most tax-efficient method of extracting profits from a company.
Providing that pension contributions are not deemed excessive for the duties carried out by the director/employee, such contributions can be deducted from the company’s taxable profits. Consequently, these contributions will receive a corporation tax relief.
If pension contributions do not exceed the director/employee’s pension ‘annual allowance’ they will not be subject to tax on the contribution made. For 2019/20, the basic annual allowance is £40,000. If you have an income of over £150,000 in a tax year, then your annual allowance for that year will reduce on a tapered basis. For every £2 of income above £150,000, your annual allowance will reduce by £1. The maximum reduction is £30,000 so anyone with an income of £210,000 or more will have an annual allowance of £10,000. If the annual allowances in the previous 3 years have not been used, there is the potential to carry these forwards and receive tax relief in the company on a large contribution.
Given this tax efficiency, pension contributions should be considered where the director/employee does not need the funds in their hands.
If an individual owns a property which the company uses in its trade, rent could be charged to the company for the use of that property. The rent (less any allowable expenses) is chargeable to income tax but are not earnings for NIC purposes (thereby enabling an NIC-free extraction of funds). The rental payments are deductible for the company for corporation tax (subject to reasonableness).
The disadvantages of receiving rental income from the company is that the income is charged at the non-savings rate of 20%, 40% or 45% (thereby making it less tax efficient than taking a dividend).
Overall, the payment of rent can be considered to be more tax efficient than taking dividends when taking into account the income tax and corporation tax position, if the shareholder and property owner is a basic rate income tax payer and the entirety of their share of the rental profit is subject to basic rate income tax.
The most significant downside is that by charging a rent you restrict your ability to claim capital gains Entrepreneurs Relief (ER) (resulting in a 10% capital gains tax rate) on any gain arising on the sale of the property.
Please also note that irrespective of whether rent is paid, holding property outside of a trading company (when a property from which the trade is carried out is held personally) is usually inefficient from an inheritance tax perspective.
Some directors/shareholders lend money to the company, either by simple loan account or via a subscription for loan stock or debenture stock.
The director/shareholder can charge interest to the company in this scenario. The interest received is chargeable to income tax but is not classed as earnings for NIC purposes (again enabling an NIC-free extraction). A rate of 0% applies to interest within an individual’s savings allowance. If the individual does not have higher rate income, the savings allowance is £1,000. If the individual has higher rate income but does not have additional rate income, the allowance is £500. It is nil for individuals with additional rate income. The interest payments are normally deductible for the company under the loan relationships rules (subject to reasonableness).
Where a UK company pays interest to an individual, it must withhold 20% of this at source for payment of income tax (not taking into account the savings allowance) and submit CT61 returns to HMRC which can be a burden from an administration perspective.
It should be noted that loans to companies do not qualify for inheritance tax Business Property Relief (BPR). This can be managed by using planning.
With Capital Gains Tax (CGT) rates on investments being 10% for basic rate taxpayers and only 20% for higher/additional rate taxpayers, this way of extracting funds could be ideal as it generally compares favorably with the effective rates of income tax on remuneration and dividends. If Entrepreneurs’ Relief (ER) is available, the CGT rate is reduced to 10%, regardless of the taxpayer’s level of taxable income. In addition, all taxpayers have an annual exemption which means that the first £12,000 per annum (in 2019/20) of capital gains are not charged to tax (and typically most UK taxpayers do not make use of this CGT exemption). Cash taken out of the company can be treated as capital proceeds for CGT purposes if extracted in the following ways:
- Company Purchase of Own Shares (CPOS);
- Capital redemption/return of capital; or
- Distributions on winding up of a company.
Company Purchase of Own Shares (CPOS)
Normally payments by companies to buy back shares from individuals are treated as income distributions (i.e. dividends). These distributions are therefore liable to income tax at the dividend rates as discussed above. However, if certain conditions are met, the cash received from the buy-back is treated as a capital sum on disposal of the shares. This gives rise to a capital gain in the hands of the shareholder. For most shareholders (unless they are basic rate income tax payers and basic rate income tax will be payable on the entire proposed amount), the capital route will be beneficial, particularly if Entrepreneurs’ Relief is available. This capital treatment only applies to purchases of own shares by unquoted trading companies where the repurchase is made either to benefit the trade or to discharge an IHT liability as a result of death.
Where the individual is seeking capital treatment under the “benefit of trade” route, there are several other conditions which must be satisfied.
A clearance procedure is available in order to request HMRC’s opinion as to whether proceeds will be treated as a capital distribution (as opposed to a dividend). Advice should be sought based on your specific circumstances.
Capital redemption/Return of capital
A company may restructure its share capital or issue redeemable securities to return money to shareholders. This can give shareholders flexibility in when and how to take their money.
Distributions on Winding up of a Company
There may eventually come a time when the company has run its course, is no longer required by its shareholders and can therefore be wound-up. The company will then cease trading, sell its assets, discharge its liabilities and, if there are any surplus assets left (most commonly cash), it will distribute those assets to its shareholders.
Prior to 6 April 2016 distributions received on a winding up or liquidation of a company (or in a capital redemption/return of capital) were always treated as a capital distribution. Since 6 April 2016, such a distribution can be deemed as a dividend and taxed as such (resulting in a significantly higher tax charge in most cases). Consequently, there is a risk here, particularly for companies with reserves. This is an area where advice should be sought.
It is possible to apply to HMRC for a clearance in order to seek their opinion as to whether these anti-avoidance provisions would be involved (and thus the distributions being treated as dividend income).
Care also needs to be taken where a shareholder will be involved in a similar sector in the future.
Private Investment Schemes
Some private investments can offer a way of reducing the amount of tax an individual will pay during the year of extraction. Enterprise Investment Scheme, Seed Enterprise Investment Scheme and Venture Capital Trust schemes encourage investments in small, unquoted trading companies and would therefore be classed as a high risk investment, but would allow an individual to claim income tax relief on the investments made using the funds extracted from the company.
There is obviously a big investment decision to be made here, as well as considering the tax relief on offer. You should consult an advisor.
It is also worth noting that EIS and SEIS are available to companies wishing to attract investment.
Enterprise Investment Scheme (EIS)
The Enterprise Investment Scheme is designed to help smaller, higher-risk companies raise finance. The investor can subscribe up to a maximum of £1m (or £2m where the company is knowledge-intensive) and claim tax relief of 30% of the amount invested. To qualify for the relief, the shares have a holding period of 3 years but any disposal following this period will be exempt from any capital gains tax. There is also the attracting feature that the relief can be carried back to the preceding tax year.
EIS investments also offer deferral relief against capital gains tax. Capital gains arising in the 12 months before investment or 36 months after can be deferred up to the amount of the investment. The gain is crystallised when the EIS shares are sold, however if the 3 year holding period was met, only the original gain is chargeable meaning additional annual exemptions can be utilised.
Seed Enterprise Investment Scheme (SEIS)
SEIS offers great tax efficient benefits to investors in return for investment in small and early stage startup businesses in the UK. It was designed to boost economic growth in the UK by promoting new enterprise and entrepreneurship. This scheme offers a higher relief percentage of 50% of the amount subscribed but the maximum investment is capped at £100,000. The holding period for the shares is 3 years, similar to EIS, and gains on disposal will be exempt following the 3 years. SEIS income tax relief can also be carried back to the preceding tax year.
A more beneficial capital gains reinvestment relief (when compared to the EIS deferral relief) is available for SEIS investments.
Venture Capital Trusts (VCT)
A Venture Capital Trust (VCT) is a company whose shares trade on the London stock market which aims to make money by investing in other companies. These are typically very small companies which are looking for further investment to help develop their business. The maximum investment for VCT shares is £200,000 per annum and relief is offered at 30% of the amount subscribed. Any gains from the disposal of these shares will be exempt from CGT provided the shares are held for a minimum period of 5 years. Any dividends received by the investor from the VCT made with the permitted maximum of £200,000 per year would be exempt from income tax.
This publication has been prepared by RRL LLP. It is to be treated as a general guide only and is not intended to be a comprehensive statement of the law or represent specific tax advice. No liability is accepted for the opinions it contains, or for any errors or omissions. All rights reserved.