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Extracting profit from your business sometimes seems as hard as making the money in the first place!
At Advizertech we are experienced in guiding business owners, like you, through the various options that are available and creating a successful plan to help improve your own bottom line.
The Usual Way
Most business owners draw a lower salary and make up the rest through dividends. This is usually because their accountant has advised that this is most tax efficient way.
The big saving on dividends compared to salary is National Insurance Contributions, both employer and employee. Although the Dividend tax free allowance has come down to £2,000 there is still a marginal tax advantage in taking the dividend route.
So what’s the problem?
In order to distribute the dividend the company needs to have made the profit and paid corporation tax. As soon as the business owner moves into higher rate tax the dividend is taxed at 32.5%.
For example, if you voted yourself a dividend of £40,000 that was in your Higher Rate Band of income it would cost you a massive £22,382 of additional tax.
Corporation Tax £9,382
Personal Tax £13,000
Additional Net Income £27,000
It is therefore very expensive for business owners to extract profits over and above the lower rate tax band.
So what options are available?
Pension contributions made by the business do not suffer corporation tax at 19% nor national insurance at 13.8%.
Furthermore, when the benefits are taken 25% can be taken cash free and the balance is taxed at your marginal tax rate.
If HMRC ‘Wholly & Exclusivity’ rules are satisfied, the company could pay up to £40,000 per year into a pension scheme. You may also be able to Carry Forward three years relief allowing a further £120,000 to paid in, potentially saving significant amounts in Corporation Tax.
Really profitable, cash rich companies may be able to extract around £100,000 per annum into a specialist type of pension scheme. It is also perfectly legitimate to utilise unused allowances, which could mean a massive £400,000 company contribution in one year.Of course, you cannot access your pension pot until you are at least 55 and a major consideration is living expenses. It may be that the level of living expenses taken from the business does not need to be as high after 55, but this would depend on the size of your accumulated pension pot.
What is the EIS?
The Enterprise Investment Scheme was established by the UK government in 1994 to encourage individuals to invest in small unquoted trading companies. By way of incentive, the government introduced tax benefits for investments into such companies.
The most significant tax benefit is 30% income tax relief on investments up to £1M. Additionally, investors can benefit from the performance of the underlying EIS companies.
Can the Enterprise Investment Scheme improve the tax efficiency of extracting profits from my business?
The answer is “yes” and “no”.
“Yes” in the sense that the Enterprise Investment Schemes (EIS) is a very tax efficient way of investing the net dividends, affording tax relief of 30%.
“No” in the sense that profit itself would need to be extracted probably through dividends and so would already have been taxed at either 7.5%, 32.5% or 38.1%.
How does it work in practice?
If you take £50,000 of dividends all of which falls into the higher rate tax band, you will pay 32.5% in income tax. Of course, this is after 19% corporation tax has been paid on the profits.
You will personally pay £16,250 in income tax on £50,000 dividends, leaving you with £33,750 net. If you then invest £33,750 in the EIS, then you will receive tax relief at 30% providing you hold the investment for at least 3 years.
The tax relief would equate to £10,125 which when added to the net dividend would inflate the net income to £43,875, an effective rate of income tax of 12.25% compared to 32.5%.
Are there any other considerations?
As mentioned above, the investment must be held for 3 years to qualify for the tax relief.
However, the main consideration is risk to your investment, since investing in unquoted trading companies carries significantly higher risk than investing in say FTSE 100 or 250 companies.
Risk can be mitigated by investing in a portfolio of unquoted trading companies under the investment control of companies specialising in selecting appropriate qualifying companies.
Furthermore, EIS investors can take advantage of loss relief. This means the impact of losses made on individual companies can be reduced. This would apply even if you hold a portfolio of EIS companies that delivered a positive return overall.
If I left profits in the business, surely I would benefit from Entrepreneurs’ Relief when I sell the company?
Entrepreneurs’ Relief is given subject to satisfying certain conditions on the sale of a business and is available to sole traders or partners as well as company directors with a 5% or more shareholding. This relief can reduce the capital gains tax to 10%.
However, remember that any profits retained by the business will already have been subject to Corporation tax at 19%.
Other key points to consider include:
As you can see, with some careful planning, it is possible to extract profits from your business in a tax efficient manner, making effective use of paying salary, dividends and pension contributions.
You can also see how you can invest dividends tax efficiently in such vehicles as the Enterprise Investment Scheme which need only be held for 3 years. This is particularly useful if you have dividends surplus to immediate needs with adequate pension provision for the future.
Through our expertise, Advizertech can help you maximise the tax efficiency of extracting profits from your business. We will work closely with other professionals such as your accountant to help you achieve your goals.
1. For pensions - A pension is a long term investment. The fund value may fluctuate and can go down. Your eventual income may depend upon the size of the fund at retirement, future interest rates and tax legislation.
2. For EIS - Your capital may be at risk. The tax treatment is dependent on individual circumstances and may be subject to change in future. In addition, the availability of tax reliefs depends on the companies invested in maintaining their qualifying status. Please refer to the HM Revenue & Customs website for further guidance on the tax relief available on EIS investments.
3. Tax planning advice is not regulated by the Financial Conduct Authority.
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