Jennifer Adams considers how new business owners might be paid to achieve maximum tax efficiency, depending on the type of business.
Most employees are used to having tax and National Insurance contributions (NICs) taken from their salaries before receiving the cash, usually directly into their bank accounts. That all changes on becoming self-employed or a partner or company director as the owner needs to ensure that they comply with the tax rules and set aside monies to pay their tax bills.
Self-employed or partnerships
Being self-employed is the simplest form of business setup. The business owner does not take remuneration as they are taxed on the total profit made in any accounting period. The owner gets to keep all the profits, although the downside is that they are also personally liable for all the business debts. Profits are not taxed separately but form part of the sole trader’s taxable income, together with income from other sources, such as other employment or investment income. Any monies invested in the business to get it going are not treated as a loan, and if the business folds, the monies will not be repayable. Any monies taken from the business bank account are also not tax deductible.
Partnerships are a group of self-employed persons working together in one business; as such, each partner is separately liable for their own tax on all sources of their income. HMRC cannot proceed against other partners if a partner fails to pay their tax bill. Partnership profits have to be agreed as a whole, with no partner being able to agree on an adjustment to their share of the profits independently of the others – their share being set down in the partnership agreement.
Directors
In comparison, incorporating a business can lead to flexibility in the method of remuneration leading to tax planning opportunities. Employees are usually treated as receiving their salary with the earnings period for NIC being determined by their regular pay interval, however, the position is different for directors. For tax and NICs purposes, they are treated as receiving a salary when approved by the company. The earnings period is a tax year, even if they are paid monthly or they leave during the year, or the company closes. Therefore, although the money might not be taken, the amount can be left on the directors' Loan account as a credit until the company can afford to pay; meanwhile, the company can claim a tax deduction as if payment had been made.
Salary or dividend?
Taking or being voted a salary is not always tax-efficient in the first year of business, particularly if the director had previously been employed, as a tax refund may be due on the balance of tax allowances not used (if the director left part-way through the tax year).
Usually, dividends are the most tax-efficient income; however, taking a dividend pre-set up or pre-first income payment cannot be made as the rules state that a dividend can only be paid if the company has retained profits. Therefore, if a director wants (or needs) to withdraw monies from the company, it must be in the form of a salary as at the beginning of a company's life, there will be no retained profits.
Practical tip
Tax relief is only allowed on an expense if the cost would be deductible if the trade had already started. Following this condition, a claim for tax relief on salary in the first year should be straightforward but be aware that payment must not be disproportionate to the work done for the business (i.e., it must be 'reasonable').
