Lee Sharpe considers some of the tax-efficient methods available to director/shareholders for extracting cash from a company.
For director/shareholders, there are numerous routes to extract funds. Some are more tax-efficient than others and no one option is guaranteed to suit everyone. We have set out below those which are relatively likely to benefit most owner-managed businesses (OMBs).
1. Dividends
This should prove the most popular route for many individuals who are shareholders and directors (or indeed shareholders who are employees). They are tax-efficient and avoid National Insurance contributions (NICs) as well – for both the individual and the company.
It should be noted that the company pays dividends out of its post-tax profits – there is no corporate tax relief for a dividend payment, which is different to normal salary or bonus payments.
Example 1 – Dividend v Bonus
Fred is a director/shareholder in his own company. After accounting for all other expenses before tax, the company has £10,000 of profits that it can pay out. Fred pays tax at the basic rate of 20%, as does the company.
Starting with the same amount of money, Fred is more than £2,000 better off taking a dividend as against a bonus.
Advantages:
- tax/NI-efficient; and
- the company can administer its dividends directly: the paperwork is relatively straightforward.
But note:
- dividends ‘float to the top’ of most types of income, so if your other income for the year takes you into (say) the 40% tax band, then any dividend income has to be taxed at the higher rates – although even then an effective 25% income tax rate is still advantageous;
- take care to ensure that paperwork is properly prepared and timeously recorded – HMRC says interim dividends are paid only when the appropriate entries have been made and the funds have been placed unreservedly at the shareholder’s disposal (see HMRC’s Corporation Tax manual at CTM20095);
- the company can pay dividends only if it has sufficient ‘distributable reserves’ – accumulated profits not yet paid out – to do so;
- dividends have generally to be paid out in proportion across the same class of shareholding, which can make them unwieldy; and
- dividends do not ‘count’ as relevant earnings for pension purposes, so if you want to make a substantial pension contribution yourself, you need to have either salary (including bonuses and taxable benefits) or trading profits first.
2. Tax-favoured benefits
Certain non-cash benefits can be paid out without attracting a tax or NIC charge – and still be tax-deductible for the company. Many of the ‘exempt’ benefits are quite modest (such as homeworking arrangements or mobile phones), but there are one or two which can be quite valuable:
i. employer pension contributions ;
ii. employer supported childcare, such as childcare vouchers, workplace nurseries or directly-contracted childcare (rare); and
iii. provision of office equipment at home for work purposes.
Employer pension contributions do not need ‘relevant earnings’ so substantial payments can be made without reference to the shareholder/director’s earned income for the year, subject to the annual and lifetime allowances.
Advantages:
- no tax or NICs charge for the director/shareholder and potentially tax relief for the company.
But note:
- there is a requirement that the expense be incurred ‘wholly and exclusively’ for the purposes of the company’s trade, in order to be deductible. But it is practically difficult for HMRC to challenge even very large employer pension contributions, because there is such a wide range of remuneration packages in the ‘real’ world of OMB companies; and
- the choice of tax-favoured benefits is relatively small and will not suit everyone, all of the time. Employer-supported childcare potentially allows up to £55 per week tax-free per employee, which is particularly useful for husband-and-wife type OMBs. Note that childcare vouchers will cease to be available for new schemes from Autumn 2015 (existing schemes may continue).
3. Salaries to other family members
Where, for example, spouses or children do not already have income to utilise their tax-free personal allowances, it may well be worth engaging them in the business, to ensure that the family as a whole makes best use of available allowances and lower tax bands.
Advantages:
May be free of tax and even NIC depending on the level of remuneration paid – and may be deductible for the company.
But note:
Any payment and/or benefits conferred must be commensurate with the work undertaken, otherwise the payment may not be tax-allowable for the company – and could even be taxed as income of the original earner.
If you can afford not to take the cash immediately
Although OMB director/shareholders often need to withdraw all or most of the company’s profits as soon as they arise, there can be substantial benefits to refraining from taking all of the company’s profits as soon as they’re earned.
4. Liquidate the company
Where a company’s funds are distributed in a formal liquidation, distributions are deemed capital in nature, and subject to capital gains tax (CGT) rather than income tax. The highest rate of CGT is 28%, comfortably lower than higher (or additional) rate income tax (a formal liquidation may not be required where the funds amount to £25,000 or less). This route is particularly beneficial where the capital route is eligible for entrepreneurs’ relief and taxable at only 10%.
Example 2 - Ending the company
John runs a hairdressing business, which each year generates £40,000 more in post-tax profits than he requires. He wants to retire in about 10 years by which time he will have accumulated a further £400,000. Using today’s rates:
Advantages:
Provided the company is eligible for entrepreneurs’ relief, the liquidation route offers a very substantial saving when compared to a simple bonus.
But note:
- a formal liquidation can cost several thousands of pounds; and
- HMRC may challenge eligibility for entrepreneurs’ relief where an otherwise qualifying company holds large cash balances, on the basis that the company’s non-trading activities are ‘substantial’. However, the tax case (Famer's Executors) v CIR [1999] SSCD 321 (SpC 216) should assist broadly provided the cash funds are not actively managed. HMRC can also challenge the CGT route by invoking ‘transactions in securities’ anti-avoidance legislation, although this does not apply to a simple company liquidation, since there are no relevant transactions in securities. But if one company were liquidated only for the same trade to be carried on by a successor company, HMRC might try to use the legislation to have the capital receipt treated as an income distribution (see CTM36850).
5. Take your time and dividends slowly
An alternative to liquidation is simply to wind down the trading activity, hold on to the company and withdraw dividends up to the 40% tax threshold (currently about £42,000) every year, like an unauthorised pension investment, until the funds are exhausted.
Advantages:
- dividends up to the higher rate tax threshold are normally free of income tax and NICs; and
- fairly simple to administer.
But note:
- there are some additional administrative costs, etc., to keep running the company; and
- the company will not be trading, so any net income will be taxed at the main rate of corporation tax (21%, although this is due to come down to 20% next year). Likewise there may be little scope to claim tax relief for any expenses.
6. Take a Loan?
Many readers will be aware that there is a special tax charge (under CTA 2010 s 455) when a company lends money to a shareholder. There is also normally a taxable benefit in kind when a director or employee enjoys an interest-free loan (or where the interest charged is less than HMRC’s ‘official rate’ – currently 3.25%). But the special tax charge is ultimately refundable to the company when the loan is repaid or written off, and the effective annual tax charge for even a 40% taxpayer is currently just 1.3% a year, which ceases following the tax year of termination of the employment.
The annual charge can also be avoided if the loan is applied for a qualifying purpose, such as to invest in a personal property business. Advisers are generally wary of scenarios which result in a temporary ‘s 455 tax charge’, but if the company has sufficient funds – and particularly if the loan may be applied for a qualifying purpose – this ‘dark horse’ may reward careful consideration.
Practical Tip:
This article has pointed out some possible routes to extract company funds tax-efficiently. Note that long-term plans are subject to changes in tax rates and the reliefs allowed in the legislation, so it is worth checking the optimal route periodically. It is also worth bearing in mind that certain non-tax issues, such as pensions and mortgages, may be influenced by the composition of your ‘remuneration package’.
