Chris Thorpe looks at tax-efficient ways of extracting profits from a limited company.
Upon incorporating a business, probably the most important issue for the director/shareholder and their tax adviser is how to extract the subsequent profits.
Before this time, the same individual would have simply taken some cash out of the ATM on the Friday evening and thought nothing of it; he has been taxed on the profits, he and business are one and the same, and that’s all there is to it. However, following incorporation that same money is the property of another person (i.e. the limited company), although that legal distinction is unlikely to be appreciated so early on (if at all!). Therefore, the money needs to go to our shareholder/director through the proper channels, and the most common two are those of the salary and the dividend. The issue has always been; how much of each?
How much in dividends?
A very general answer is that if the company is in a position to pay dividends, the dividend should make up the bulk of our individual’s remuneration package. The income tax rates for dividends are lower than for earned income; dividends attract no National Insurance contributions (NICs) liabilities; and there is a dividend allowance giving the first £2,000 an income tax rate of 0%.
However, unlike a post-tax dividend, a salary is tax-deductible for the company; also, if pension contributions above £3,600 are to be made by the individual they will need a salary above that amount to create the necessary pensionable earnings (which does not include dividends). Therefore, a fine balance should be sought, with the bulk of the remuneration being in the form of dividends but with some salary to ‘max out’ the NICs thresholds and personal allowance.
Even with the reduction of the dividend allowance from £5,000 to £2,000 in April 2018, the lower income tax rate along with that lower allowance does mean that the dividend is the primary form of payment; but the salary should be pitched at the optimum level. Too much salary will take up a basic rate band which would otherwise give a dividend a 7.5% tax rate, and would attract an NICs liability besides; too little would deny the company some tax relief as well as the opportunity for those larger pension contributions.
Optimising salary
Putting aside consideration of pension contributions, the optimum level of salary would be the prevailing level of Class 1 NICs secondary threshold (i.e. £8,788 for 2020/21). At this level of salary, the company (i.e. the employer) makes no NICs contribution; nor does the individual pay Class 1 primary NICs; yet as they receive more than the lower earnings limit, the individual still obtains his ‘years’ for state pension/social security purposes, as well as paying no income tax on this sum within his personal allowance. This limit could be taken up to the Class 1 NICs primary threshold (i.e. £9,500 for 2020/21) without the director having to pay NICs; the company’s small secondary NICs liability would at least obtain tax relief, unlike the director against his own NICs liability.
Alternatively, the income tax personal allowance could be fully utilised and salary taken up to £12,500 in 2020/21; this would trigger a primary and secondary NICs liability, but aside from the company’s tax relief, if the director wishes to make personal pension contributions, the greater amount of pensionable income will bring this consideration to the fore. Realistically, this is the only reason why the salary would be brought up to the personal allowance.
Practical tip
Another possibility is that other sources of income from the company could be sought; certainly employer pension contributions, but where possible, interest. A personal savings allowance combined with the £5,000 0% tax rate and lack of NICs makes interest a relatively tax-efficient way of extracting profits from a company. Loans to the company or credited to directors’ loan accounts following incorporation would clearly be a prerequisite; but if the circumstances were such, this would also be factored into the remuneration balance.
