Our simplified guide to tax efficient extraction of money from your company, part of a new series on Tax Made Simple
One of the most important aspects of our work at Schoolgate is helping our clients get the most out of their business as possible, financially speaking, when it comes to paying tax. It is almost inevitable that the idea of ‘tax avoidance’ stirs up uncomfortable emotions for most business owners, particularly with high profile imbroglios such as the Paradise Papers making regular appearances in the media. However, at Schoolgate, we believe that not only is it important to be fully aware of the limitations of your tax obligations, but it is even irresponsible as a business owner to pay more than you have to by law if you approach these obligations in an ethical and common-sense manner, as we encourage all our clients to do.
As a result, we have decided to begin a new series, Tax Made Simple, for business owners to provide a concise and understandable guide to what you should pay and how to save money on your tax bill without registering a legal entity in Bermuda.
Our first instalment will cover a general overview of profit extraction strategies, i.e. how to take money out of your company in the most tax-efficient way.
Part 1 – Salary & Dividends
The most common ways of taking money out of a company are via salary payments and dividends. Most people are familiar with the way salaries are taxed, with a personal allowance which is tax free (£12,500) and various thresholds which are taxed at different rates (20% beyond personal allowance; 40% on earnings above £50,000*).
Dividends are sums taken out of the reserve profits of the company. Until April, you could earn £5,000 in dividends tax-free. Unfortunately for business owners, this has dropped to £2,000 for 2018-19 and continues at this rate for 2019-20.
A fairly common tax planning strategy is to take a low basic salary, below the personal allowance amount, so that it does not attract income tax, but high enough so that you are paying National Insurance and are therefore entitled to the benefits this entails. You then make up the balance with income from dividends, which are not subject to National Insurance. However, unlike salaries, dividends are not tax-deductable. This means that the more money you take from the company as a salary, the less corporation tax you have to pay on the profits, but this is not true of a dividend. On the flip side, since you have already paid corporation tax on the company profits, the taxes on dividends are lower than those on salaries (only 7.5% if your overall income is below the £50,000 threshold, and 32.5% if above). As a result, there is a balance between how much to take as salary and how much as a dividend (bearing in mind taxes and National Insurance payable overall).
* Please note rates differ in Scotland
Part 2 – Pensions Payments & Tax Relief
Pension payments are subject to tax relief, which means that qualifying taxpayers can get relief (i.e. a reduction on the amount of tax owed) on private pension contributions worth up to 100% of their annual earnings (subject to the overriding limits). This means that you can pay an amount up to 100% of your main job earnings, i.e. gross salary including any bonuses, profit-related pay and taxable benefits. It does not include other forms of income like dividends.
The annual allowance (limit) for tax relief on pensions is £40,000 for the current tax year. You can also carry forward any unused annual allowance from the last three tax years if you have made pension savings in those years. Be aware, however, that if you take money out of your pension pot, you may have to pay tax on contributions over a much lower figure of £4,000. There is also a lifetime limit for tax relief on pension contributions, which currently stands at £1.03 million.
Tax relief is paid on pension contributions at the highest rate of Income Tax you pay.
This means that:
- Basic rate taxpayers get 20% pension relief
- Higher rate taxpayers can claim 40% pension relief
- Additional rate taxpayers can claim 45% pension relief
This means that if you are a basic rate taxpayer and you pay £8,000 into your pension, HMRC adds £2,000 to your pension; if you pay £32,000 in, HMRC will add £8,000 (an easy way to work this out is to take the contribution and divide by 0.8).
Higher rate taxpayers can pay £24,000 to make up their £40,000 contribution (divide by 0.6) and additional rate taxpayers £22,000 (divide by 0.55).
The first 20% of tax relief is usually automatically applied by your employer with no further action required by a basic-rate taxpayer. Higher rate and additional rate taxpayers can claim back any further reliefs on their self-assessment tax return.
The above applies for claiming tax relief in England, Wales or Northern Ireland. There are some interesting regional differences if the taxpayer is based in Scotland. If a Scottish taxpayer is paying Income Tax at the starter rate of 19% they will get tax relief of 20% and are not required to pay back the difference. As with the rest of the UK, basic rate taxpayers in Scotland will pay 20% Income Tax and get 20% pension tax relief. There are also three higher rates, an intermediate rate of 21%, a higher rate of 41% and an additional rate of 46% where further tax relief can be claimed.
Equally, if the company pays any pension contributions, this reduces the overall profits and subsequently decreases the overall amount of corporation tax the company has to pay, making it an effective way of saving tax as well as being an important tax-free benefit to employees.
Other forms of relief
Although the government is continually clamping down on non-taxable payment and benefits for employees, there remains an eclectic list of expenses that are tax exempt.
Some of the non-taxable benefits include the following:
- Annual parties; an annual Christmas party or other annual event offered to staff generally is not taxable on those attending, provided that the average cost per head of the function does not exceed £150. There are qualifying criteria that must be followed to ensure that there will be no taxable benefit charged to employees.
- Equipment for disabled employees; benefits provided to employees with a disability to help them with their work aren’t taxable where there is private use. For example, a wheelchair or hearing aid.
- Goodwill gifts; certain gifts received by employees from third parties (such as a gift voucher) are exempt, provided that the total value of the gift made by a donor is less than £250 in any one tax year. In addition, no tax is usually payable on goodwill entertainment provided by third parties (e.g. suppliers).
- Health-screening and medical check-ups; a maximum of one health-screening assessment and one medical check-up in any year can be tax exempt.
- Late-night taxis; an employee, who is occasionally required to work late, can be provided with a taxi home paid for by his / her employer. This taxi ride will qualify for tax exempt status if all qualifying conditions are met.
- Long service awards; long service awards made to directors and employees as testimonials to mark long service where the service is not less than 20 years, and no similar award has been made to the same employee within the previous 10 years are likely to be tax exempt. The cost of an article must not exceed £50 for each year of service.
- Relocation expenses; some relocation costs for employees, such as moving costs and purchase of certain items, are subject to tax relief of up to £8,000 as long as specific requirements are met.
- Trivial benefits; you don’t have to pay any tax on employee benefits as long as they don’t exceed £50, are not cash benefits, are not performance related and are not outlined in the employee’s contract. There are a few stipulations so get in touch if you would like to check they meet the criteria.
- R&D tax credits; a form of corporation tax relief to encourage innovation and enterprise within the UK economy. Small and medium-sized enterprises (SMEs) can claim SME R&D tax deductions totalling 230% of any qualifying R&D expenditure (from 1 April 2015). It is also possible to claim a tax credit if the company is not making a profit.
- Creative industry tax reliefs; there are 8 types of tax reliefs available for creative industries – Film Tax Relief (FTR), Animation Tax Relief (ATR), High-end Television Tax Relief (HTR), Children’s Television Tax Relief (CTR), Video Games Tax Relief (VGTR), Theatre Tax Relief (TTR), Orchestra Tax Relief (OTR) & Museums and Galleries Exhibition Tax Relief (MGETR).
- Capital Allowances; when you spend money on assets for your company (such as equipment, machinery or business vehicles) you can use your company’s Annual Investment Allowance (AIA) for relief of up to £1mn (until the end of 2020).
- Entrepreneur Relief; if you are thinking about closing down your company, you may be able to claim tax relief from Capital Gains Tax.
There is no requirement for employees to pay tax on benefits and expenses covered by concessions or exemptions, and there is also no need for them to be included on your tax return.
If you would like any further information about the information contained in this article, please get in touch to arrange a free no-obligation consultation.
Source: Schoolgate Accounting Services | 30-4-18 (updated 14-8-18, 9-7-19, 30-10-19)