In this Blog, we discuss owner managed businesses (OMBs) and profit extraction…
It is perhaps one of the commonest questions I get asked by owners of OMBs – how can I take money out of my business tax efficiently?
Clearly this question is only raised with me by individuals who are running their business activities through a company.
One very important, and often overlooked, issue is the fact that there is a clear distinction between corporate and personal money. It is unfortunately a common situation that many a business man/woman has got into problems by not appreciating the distinction and in particular the fact that tax is nearly always relevant when extracting company funds.
The current taxation regime is such that extracting profits from a company by way of dividends, rather than salary/bonus, is the most tax advantageous route when looking at the total tax take. It is for this reason that many businesses are set up as companies to enable this planning to be exploited. This is why the owners of many OMBs are typically paying themselves a modest salary topping that up with the payment of dividends on a regular basis.
The changes to the tax treatment of dividends announced in the Summer Budget have attempted to deal with this issue. However, the planning is still sound albeit the tax saving will be eroded from April 2016. The owners of OMB companies will need to be alive to this change and the message it may be sending that the planning opportunity is in the Government’s sights such that the ‘advantage’ may be further eroded over time.
There are some issues to bear in mind when pursuing dividend planning in this way:
Salaries can be paid regardless of the state of the company’s finances, i.e. the company does not necessarily have to be a profitable business and have available reserves.
It follows from the first point that dividends are only payable if there are sufficient distributable profits to make the necessary payment. Care is needed if regular dividend payments are being made during a financial year as allowance will need to be taken for expected events which might arise later in the year, i.e. just because there may be available reserves six months into the year, based on reserves brought forward and profits to date, that is not to say that there will still be available reserves at the end of the year if that business has a poor second half of the year or a cataclysmic event which wipes out profits. I have seen many a situation where companies have ended up in a position where the dividends paid earlier in the year have turned out to be ‘illegal’ and have needed to be dealt with slightly differently, when preparing the year-end financial statements.
There must be sufficient reserves to enable the payment of the full dividend on the class of shares concerned. If one shareholder decides that they do not require a dividend and choose to waive that dividend, that must be taken into account when quantifying the dividend payable to the other shareholders. As an example, if a company has distributable profits of £100 and two shareholders owning 50% of the shares which are of the same class, the maximum dividend payable to each shareholder is £50, i.e. a dividend of £100 cannot be paid to shareholder A if shareholder B decides to waive their entitlement.
The tax liability with regard to salary/bonus will be dealt with in accordance with the PAYE rules whilst the tax payable in respect of the dividend will be payable in accordance with the personal tax self-assessment regime, i.e. a balancing payment 31 January after the tax year in which the dividend is paid with payments on account 31 January, 31 July thereafter.
As a useful rule of thumb where the gross dividend payable falls totally within the 40% tax band, the tax due on the dividend is 25% of the net amount where the dividend falls entirely within the 45% band the tax due is 30.56% of the net dividend. The gross dividend is the net divided plus the tax credit of one ninth so net dividend times ten divided by nine, e.g. £100 x 10 / 9 = £111.11. The check is to ensure that the tax credit is 10% of the gross dividend. The new rules announced in the Summer Budget will remove this complication. I will have a later blog on this and the planning opportunities available in the run up to April 2016.
Other ways in which funds can be extracted from the business are:
Ensure that spouses and other family members are properly rewarded for the work that they may do for the business albeit that they may not visit the company’s premises on a regular basis. They may be supporting the business with work they do at home.
Consider charging the company rent for assets owned personally which are used in the business. Typically this will be office/factory premises that may be held personally. Income tax payable at the highest marginal rate will be due on any such income. There are some important Capital Gains Tax and Inheritance Tax implications of doing this which I will address in a later blog.
Whilst not necessarily giving immediate access to cash, pension contributions should also be considered in light of the relaxation of the rules with regard to accessing pension pots. For those business owners of a certain age this can be attractive especially if they have any element of the tax free lump sum available to be drawn from their pension arrangements.
Loans can be taken from the business if there is a short term cash need. If the loan is repaid within 9 months of the company’s year-end then the only tax payable will be on the benefit in kind resulting from the ‘cheap loan’ if no interest is paid to the company by the borrower. If the loan is not repaid within the 9 months the company will have to pay 25% of the amount outstanding. That amount will be repaid to the company as and when the loan is repaid but only when the corporation tax return for the year of repayment is processed by HMRC. So timing is critical with such planning as there are some detailed anti-avoidance rules which prevent such practices as ‘bed and breakfasting’.
There are a number of issues which need to be borne in mind when considering profit extraction, the more important of which are as follows:
The strength of the balance sheet and how this might be weakened by extractions and how this might be relevant for external users of the financial statements.
Available cash in the business. Loan accounts can be used if a dividend is required for tax planning purposes.
Cash flow implications for the individual recipients in terms of both the extraction and the tax due on that extraction.
Problems can be encountered with mortgage lenders where dividends feature heavily as part of the income stream for the mortgage applicant. In most cases it will simply be necessary for the mortgage applicant to provide the potential lender with the appropriate income and tax statements from HMRC (SA302s) which will address any concerns with regard to the discretionary nature of dividends.
Profit extraction remains a recurrent theme for OMB companies. If profits/cash do not need to be retained in the business and are required for personal use a company is perhaps not the best structure. Alternatively, if cash is not an immediate requirement for the business owner a company can be a useful way by which tax liabilities can be managed.