Alan Pink considers alternative ways of extracting profits from the family company.
The most basic form of tax planning there is, probably, in the context of the family company is considering whether its shareholder/directors should take their income out of the company in the form of salary or dividends.
Salary and dividends
All situations should be looked at on their own facts, of course, but very often the rule of thumb is as follows. Because salary, unlike dividends, gives rise to a charge to employer’s and employee’s National Insurance contributions (NICs), a nominal amount tends to be paid as salary – often enough to trigger entitlement for the year to state benefits – with the rest being paid out as dividends.
Dividends don’t attract a NICs liability other than in exceptional circumstances, and even the recent introduction of an effective 7.5% or so ‘dividend tax’ hasn’t taken away the superior attractiveness of dividends as a way of taking income out of the company.
Of course, sometimes things aren’t that simple. It may be that the shareholdings in the company are in different proportions from the amounts it wants to pay its shareholder/directors for a number of reasons.
This can sometimes be got around by setting up different classes of shares, which can therefore pay different rates of dividends to different people; but the issue is still there. It’s also true to say that, where members of a family have shares, it is normally going to be a ‘no brainer’ to pay dividends at least sufficient to use up their available £2,000 dividend allowance for the tax year – assuming they’re not receiving dividends elsewhere that use this up.
Rent and interest
But consider the following two additional alternative ways of taking income, which may exist in different situations:
- where the company occupies (or part occupies) any kind of building or space owned by the individual shareholder/director, consider the merits of paying rent for this occupation; and
- where the individual concerned has a loan account in credit with the company (i.e. the company owes them money) consider paying a fair rate of interest on this loan balance.
Put briefly, the benefit of paying rent or interest, instead of salary or dividends, is that rent and interest, providing they are not excessive, are allowable deductions against the company’s corporation tax liability; but don’t give rise to the requirement to pay over NICs to HMRC.
The following example calculations illustrate this. In all cases, I am assuming that the company has profits of £100 to dispose of; the dividend allowance has been used elsewhere; and the individual receiving the income is a higher rate (40%) taxpayer.
|
Example 1: Dividend of £100: post-tax
income
Dividend |
£ |
|
|
Company
profits |
100 |
|
|
Corporation
tax at 19% |
19 |
|
|
Therefore,
paid as dividend |
81 |
|
|
Personal
income tax at 32.5% |
26 |
|
|
Therefore,
remaining to the shareholder after tax |
55 |
|
|
|
|
|
The above example illustrates how dividends are paid out of profits post corporation tax, and the 32.5% rate is the ‘special’ rate which applies to dividends received by an individual who is a 40% taxpayer. For a basic rate taxpayer, this rate would have been 7.5%, and for a top rate (45%) shareholder the corresponding rate on dividends is 38.1%.
|
Example 2: Salary of £100: post-tax
income Salary |
£ |
|
|
Gross
pay (rounded) |
88 |
|
|
Employer’s
NICs |
12 |
|
|
Therefore,
profit all paid out |
100 |
|
|
Gross salary |
88 |
|
|
Tax at
40% |
35 |
|
|
Employee’s
NICs at (say) 2% |
2 |
|
|
Therefore,
left after tax & NICs |
51 |
|
|
|
|
|
It will be seen that, because of the impact of NICs, the shareholder in this case only has £51 out of the £100 profit which the company made, giving an effective ‘tax’ rate of 49% (rounded), against the 45% effective rate going down the dividend route.
We don’t really need to do corresponding calculations for rent or interest because both of these, on the assumptions we have made, would be subject to a straightforward 40% tax rate, noticeably better than either the salary or the dividend route.
Do note, though, that the above figures, though ‘typical’, would be different if the circumstances were different in certain key respects. There’s no substitute for crunching the numbers in each separate case.
Drawbacks of rent or interest
Paying either rent or interest as an alternative to remuneration or dividend would seem to be a ‘no brainer’. Why, then, is it actually used so rarely as an income extraction technique in practice?
I suspect that the main reason is that circumstances very often don’t fit in. The company may be occupying its own property, or at least not occupying a property owned by the shareholder/director. And, far from being owed a lot of money by the company, a more frequent problem is that the director’s loan accounts are overdrawn against the company.
But even where circumstances allow, there are drawbacks of each method of profit extraction, which may or may not be decisive:
- where interest is paid by a company to an individual, there will normally be the requirement to deduct income tax on a quarterly basis and account for it to HMRC. Whilst this basic rate deduction doesn’t increase the overall tax liability or change the overall tax position in any way, it is an administrative hassle;
- where the individual shareholder/director owns property which the company occupies, entrepreneurs’ relief from capital gains tax (CGT) can be compromised if the company pays rent. In the situation where the company is sold and the individuals also sell the property which the company has hitherto occupied, entrepreneurs’ relief is only available to the extent that a full market rent has not been paid by the company for its occupation. The origin of this rule, and its rationale is obscure, but it is certainly one which can lead to nasty surprises in the future.
In cases where a sale of the property at the same time as the sale of the company is unlikely, however, this latter problem can be safely disregarded; because there would be no questions of entrepreneurs’ relief in that event.
Other options
All of the above assumes that the extractions by the individuals from the company have to be in the form of income. This isn’t necessarily the case where, for example, the company owes money to the individual on loan account. It can be more tax efficient, rather than paying interest on the loan, simply to pay the loan back wholly or partially. In this way, the money in the company can be extracted in capital form and, therefore, tax-free.
Other, more ambitious, alternatives exist of transferring assets into the company at value and drawing down on the resultant credit balance. Whilst this may lead to a CGT charge, sometimes this charge will be significantly less than the income tax that would have been paid by drawing the same value out in income form as salary, dividends, rent or interest.
