Chris Thorpe looks at some less commonly used methods of extracting profits from a limited company.
One of the old chestnuts which accountants are often asked is whether a sole trader/partnership should incorporate into a limited company. There’s no one deciding factor; profit levels, nature of the business, risks inherent are amongst the factors to consider, but another is profit extraction.
Clearly, the owner of a limited company will want to extract enough profit to live; so what’s the best way of going about it?
The ‘usual’ ways
Generally, receiving profits largely through dividends is the most tax-efficient method. With the dividend allowance of £2,000 and income tax rates of 7.5%, 32.5% and 38.1% (for basic, higher and additional rate taxpayers respectively), dividends attract a lower overall tax liability for the individual shareholder than salary.
However, it’s not as rosy as it first looks. Firstly, being net profits of the company, those dividends will already have been subject to corporation tax of 19% and without the benefit of any tax relief for the company, thus creating a double taxation scenario. Secondly, as investment income, dividends are not pensionable – meaning they cannot attract tax relief if invested into a pension scheme. More recently, following the numerous lockdowns, those company owners who wished to claim the government’s self-employed income support scheme have been turned away as one of the scheme’s criterion is that no more than 50% of one’s income can be in the form of dividends. Company director shareholders will usually pay themselves a salary, but rarely is it more than the dividends they receive.
Salaries attract tax relief for the company and are pensionable, but they also attract a higher income tax rate, as well as National Insurance contributions (NICs). Therefore a balance is usually struck to take out as much in dividends as possible, but with as much salary to offset the dividend disadvantages as possible.
What are the other options?
Tax-free benefits-in-kind may be feasible: mobile or smartphones; fully electric cars; employer pension contributions; cycle to work scheme. These are all income tax and NICs-free for the director.
Charging the company a market rent for the use of the director’s house or the business premises will still attract an income tax charge, but no NICs. However, it is another source of investment income, and the £1,000 property allowance cannot be used with connected companies. Also, charging a market rent for what is now an investment asset will nullify the possibility of claiming business asset disposal relief (formerly known as entrepreneurs’ relief) for capital gains tax purposes on associated disposals (i.e. on assets owned personally and used by one’s company). Externally-held assets can only qualify for 50% business property relief for inheritance tax (IHT) purposes, too. Placing business premises within a pension scheme and then charging market rent may be worth considering, if feasible.
Charging the company interest is another option. If there is a director’s loan account (DLA), interest at a commercial rate can be charged. The director has a personal savings allowance of up to £1,000, plus potentially (depending on salary levels being at or below the personal allowance) a £5,000 savings band at 0%. Like with rent, no NICs is charged on interest. However (also like with rent), a large DLA might cause IHT problems further down the line.
A nuclear option would be to liquidate the company via a members’ voluntary liquidation. All profits would be released and taxed as capital gains, but it means the owner would have to do something different for the next two years. Since 2016, the continuation of the same or similar trade within that time could render those liquidation proceeds being taxed as income rather than capital.
Practical tip
Careful planning is therefore needed about the individual’s own income needs, their circumstances and the company’s financial position, but salary and dividends might not be the only options available to enjoy the fruits of one’s labours.
