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Tax efficient methods for profit extraction - news article image

Tax efficient methods for profit extraction

12 Sep 2017

3 minute read

When it comes to extracting profit from a business, there are numerous options for director-shareholders, and many can be overlooked. It’s important, therefore, to understand the options and find the best route according to circumstances and desired outcome. 

Dividends 

Dividends are often used, in combination with remuneration, to obtain the most tax efficient extraction of profits when the business is carried on through a company. For many years it has been attractive to pay a small salary that is topped up with dividend payments. This enables, tax efficient use of the personal allowance, providing corporation tax deduction for the company but no payment of National Insurance contributions (NICs). So, a salary of £8,164 in 2017/18 is within the primary NICs threshold while providing a qualifying year entitlement to the state pension. 

When the new tax regime for dividends was introduced in April 2016, many director-shareholders found that the tax bill on their dividends was higher than before. So does this change the strategy of combining low salary with dividends? 

The Dividend Allowance of £5,000 does not change the amount of income that is brought into the income tax computation. Instead, it charges the first £5,000 of dividend income at 0% tax - the dividend nil rate. So what does this mean? 

  • First, the payment of a low salary below the personal allowance will allow some dividends to escape tax as they are still covered by the personal allowance. 
  • Second, the £5,000 allowance will effectively reduce the available basic rate band for the rest of the dividend. 

The practical effect of the new regime is that a strategy of low salary and the balance of income requirements taken as dividends will still be a tax efficient route for profit extraction for many director-shareholders. This is likely to be the case even when the Allowance reduces to £2,000 in April 2018. 

Interest 

If a director-shareholder has made loans to the company, interest could be charged. There are two separate tax breaks which can apply to savings income. One is the Savings Allowance, which is £1,000 for basic rate taxpayers and £500 for higher rate taxpayers – this allows interest to be received up to these amounts at 0% tax. 

The other is the 0% starting band – a 0% starting rate of tax on savings income, which can now potentially be applied to £5,000 of savings income. This rate is not available if ‘taxable non-saving income,’ such as earnings, pensions, trading profits and property income, exceed the starting rate limit. Dividends, however, are not included in the ‘taxable non-savings income’ and so are taxed after savings income. 

Pensions 

Pension contributions can be a tax efficient way of extracting income from a company, as long as the director-shareholder has not used their annual pension allowance. It is especially effective when the owner is either close to retirement or has no urgent need for cash. This option now has increased flexibility with the ability to draw from a pension after the age of 55. 

Research & Development 

Since 1 April 2015 the R&D tax credits for SMEs has increased from 225% to 230%. However there can be no R&D uplift on dividends, only on salary. Therefore extracting a salary (as opposed to a dividend) potentially becomes a lot more tax efficient. 

Next steps? 

First, it is essential to for director-shareholders to reassess the efficiency of their current income extraction methods, followed by an assessment of alternative methods. While it is evident that the tax system allows substantial savings with appropriate planning, sufficient care is required. At Shaw Gibbs, we are well equipped to guide our clients through every step of their journey to ensure they are making the most of the tax breaks. 

Tax efficient methods for profit extraction - news article image

Author:

Christy Kennedy

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