Sarah Bradford considers options for extracting profits from a company in a tax-efficient manner in the 2024/25 tax year.
----------------
This is just one area of business taxation covered in our newly released tax report 'Tax Planning for Family Companies'. Save 40% Today!
----------------
A company is a separate legal entity, distinct from the shareholders that own it. Consequently, if the directors and shareholders want to use the profits made by the company for their personal use, they will need to extract those profits first. There are various ways in which this can be done; some are more tax-efficient than others.
If you are a company owner, the optimal profit extraction strategy will depend on your personal circumstances, including what other income you have, the allowances you have available and the amount of profits you need to extract. It will also depend on the company’s financial position and the level of its retained profits. While it is arguably worthwhile extracting profits where this can be done without paying any personal tax or National Insurance contributions (NICs), once this is no longer possible, consideration should be given to whether it is necessary to extract further profits or whether they can be left in the company.
This article looks at ways in which profits can be extracted in a tax-efficient manner. As a starting point, we consider the conventional approach of taking a small salary and extracting further profits as dividends, and look at the optimal salary for 2024/25.
Taking a small salary
Taking a salary from a personal or family company is often a tax-efficient way to extract profits from the company. From the company’s perspective, the salary and any associated employer’s NICs is deductible in calculating the company’s profits for corporation tax purposes, thereby reducing the net cost to the company by between 19% and 25% depending on the rate at which it pays corporation tax.
If the recipient does not already have the 35 qualifying years needed for a full state pension, paying a salary which is at least equal to the lower earnings limit of £6,396 will ensure that 2024/25 is a qualifying year. Where the salary paid is at least equal to £6,396 but does not exceed the primary threshold of £12,570, Class 1 NICs are treated as paid at a zero rate, providing the director with a qualifying year for no NICs cost. Once the salary exceeds £12,570, contributions are payable at the main primary rate of 8% until the upper earnings limit of £50,270 is reached. Class 1 NICs at 2% are payable to the extent that the salary exceeds £50,270. As a director has an annual earnings period for NICs purposes, the relevant limits here are the annual thresholds.
Where a salary is paid to a director, the salary will be tax-free to the extent that it is covered by their personal allowance. For 2024/25, the standard personal allowance is £12,570. If the director is entitled to the allowance and it is not used elsewhere, a salary of £12,570 can be paid tax-free. As this is also the level of the primary threshold, no NICs are payable on a salary of £12,570 either, although the director benefits from a qualifying year for state pension and benefit purposes. Once the salary exceeds £12,570, tax at 20% and primary Class 1 NICs at 8% are payable on the excess. As this exceeds the corporation tax savings, it is not worthwhile.
The extent to which an employer’s NICs liability will arise on a salary of £12,570 will depend on whether the National Insurance employment allowance is available. This is set at £5,000 for 2024/25. However, a personal company where the sole employee is also director is not able to benefit from the allowance. Consequently, where the director of a personal company is paid a salary of £12,570, employer NICs are payable at the rate of 13.8% on the excess over £9,100 (i.e., a bill of £478.86) unless one of the higher secondary thresholds applies. However, as the company can deduct the employer’s NICs in calculating its taxable profits for corporation tax purposes, paying a salary of £12,570 and the associated employer’s NICs is worthwhile as the corporation tax savings (at between 19% and 25%) will outweigh the employer’s NICs due at 13.8%. In a family company where the National Insurance employment allowance is available, a salary of £12,570 can be paid free of employer’s NICs.
Taken together, where the personal allowance of £12,570 is available, the optimal salary for 2024/25 is £12,570 regardless of whether the National Insurance employment allowance is available.
If the director’s available personal allowance is different, the optimal salary will depend on their particular circumstances. For example, if the director’s available personal allowance is less than £12,570 and the employment allowance is available, it may be worthwhile paying a salary of £12,570 if the company pays tax at a rate of more than 20%, but not if the company’s corporation tax is less than 20%. There is no substitute for ‘doing the sums’.
Taking further profits as dividends
Once the optimal salary has been taken, conventional wisdom dictates extracting further profits as dividends. However, this is only an option where the company has sufficient retained profits. These are profits after tax which have yet to be distributed.
Unlike salary and bonus payments, dividends can only be paid to the extent that the company has sufficient retained profits available. Even if profitability has been maintained, rising corporation tax rates from 1 April 2023 for companies with profits in excess of the lower profits limit (set at £50,000 for a standalone company) will reduce the post-tax profits available for distribution. This may mean that the company is unable to maintain dividends at the levels paid in previous years.
Where there is more than one shareholder for a class of shares, dividends must be paid in proportion to shareholdings. This limits the flexibility to tailor dividends to the personal circumstances of the shareholder. However, the use of an ‘alphabet’ share structure whereby each shareholder has their own class of share overcomes this restriction and preserves flexibility.
Once the personal allowance has been used up, the ability to pay dividends tax-free is now limited as the dividend allowance for 2024/25 has been reduced to £500. Dividends covered by the allowance are taxed at a zero rate, although the dividends (which are treated as the top slice of income) use up part of the band in which they fall. Thereafter, dividends are taxed at 8.75% where they fall within the basic-rate band, at 33.75% where they fall within the higher-rate band, and at 39.35% where they fall within the additional-rate band.
In a family company, further profits can be extracted by paying dividends to family members who are shareholders to use up their available dividend (and personal allowances).
Pension contributions
If the director does not need the funds outside the company, it can be tax-effective for the company to make pension contributions on the director’s behalf. Contributions made by the company count towards the annual allowance but are not subject to the earnings cap. As dividends are not ‘earnings’ for pension contributions purposes, where the director takes a small salary and further profits as dividends, their ability to make pension contributions is limited to the level of the salary (or £3,600 if higher). By contrast, the company can make higher contributions, capped only by the annual allowance.
Where a director’s pension pot has reached the former lifetime allowance of £1,073,100, the abolition of the lifetime allowance and associated tax charges means that the company can now make pension contributions on the director’s behalf, providing another route for extracting profits in a tax-efficient manner.
Other options
Consideration could also be given to providing benefits-in-kind, which is tax-efficient where use can be made of an available exemption.
If the director runs the business from their home, the company can also pay rent to the director. This may be useful if there are insufficient retained profits to allow the payment of dividends, as unlike salary payments there are no NICs to pay on rent.
If the director has loaned money to the company, interest could be paid on the loan, although this will involve some administration by the company.
Practical tip
Before extracting profits from your personal or family company, review your planned profit extraction strategy to ensure it provides you with the funds that you need outside the company in a way that minimises the associated tax and NICs bill.
