Many people choose to incorporate rather than run their business as a sole trader-ship for tax reasons. So, how do you withdraw money from the company? And, what’s the best way to minimise your tax bill?
First off, you need to make sure you’re not going to be caught out by HM Revenue & Customs IR35 rules. These rules were introduced in 2000 to prevent individuals working through an intermediary (who would for all other intents and purposes be treated as an employee of the client), benefiting from reduced tax charges.
The legislation ensures that, if the relationship between the worker and the client would have been one of employment had it not been for an intermediary the worker pays broadly tax and NICs on a basis which is fair in relation to what an employee of the client would pay.
There is no set criteria used by HMRC to assess whether these rules apply in a specific circumstance. It’s all about the overall risk and control of a contract. To give you a feel, here is a list of questions you should ask yourself: Do you work under your own control or are you managed by the client? Are there occasions when clients don’t pay you and you have to write off debts? If you can not complete a job, does your contract permit you to substitute workers – i.e. do you employ staff? Do you provide your own equipment? ‘Yes’ answers to the above would imply you carried the risk and were in control of the contract. However, ‘yes’ answers to the following would indicate your contract was more like one between an employer and employee: Do you have a notice period? Do you have any employee benefits? Do you work for a single client (or have multiple clients)? Are you paid for a set number of hours regardless of work completed?
Remember, this is by no means an exhaustive list of questions. Hopefully it gives you a flavour, but we would always recommend you seek professional advice on the matter before going any further.
So, assuming you are not caught out by IR35 rules, the following explains how you could choose to extract money from your limited company and minimise your tax bill.
Pay yourself a monthly salary through your company to utilise your tax free entitlement without you or the company incurring any income tax or National Insurance. This currently equates to £148 per week, although the amount is likely to increase in April 2014 when the Government’s new £2,000 employment allowance is introduced. (No-one knows exactly how this will work at the moment, but it is likely to bring the threshold for paying NIC’s into line with personal allowance of £10,000. This could mean, employees/employers will suffer no tax below £192 a week.
Each month, transfer additional funds from the business to cover personal expenditure in the form of a director’s loan.
Declare a dividend at the year-end to cover loan amounts withdrawn throughout the year. BUT NOTE:
– Dividends can only be paid out of distributable reserves – i.e. cumulative profits made in current and previous years – so don’t withdraw more than you’re earning;
– Dividends must be agreed at a board meeting (if there is more than one company director) and meeting minutes drawn up stating amount of dividend declared;
– You must raise a dividend voucher for each shareholder entitled to receive the profits distributed stating dividend paid as net and the dividend tax credit. (See below for more info on dividend tax credits).
Dividend tax credits
This is a nominal credit which means that a basic rate tax payer is deemed to have ‘paid’ the tax arising on dividends received and a higher rate tax payer only has the incremental amount of tax to pay. Dividend tax credits will never give rise to a repayment of tax, however, as this is a purely notional credit unlike PAYE deductions.
So, how much tax will I pay?
The below example shows how much tax a company with gross profits of £55,000 employing one director could pay using the method outlined above. In this example no National Insurance is payable…
A company generates £60,000 from contracts undertaken during the year and incurs costs of £5,000 thereby generating a profit of £55,000 before payment of any salary to its sole employee – a Director.
Salary payments below the tax/ NI threshold of £7,600 are made during the year. This leaves the company with a net profit of £47,400 on which it must pay corporation tax at 20%.
Assuming there are no profits in the company brought forward from previous years, after a corporation tax charge of £9,480, the company is left with distributable reserves of £37,920 out of which it can make a dividend payment to its sole director and shareholder:
Gross profit £55,000
Director salary (£7,600)
Net profit £47,400
Corporation tax (at 20%) (£9,480)
Distributable reserves £37,920
The current basic rate threshold is £41,450, so after receiving a salary of £7,600 the director can receive a net dividend payment of £30,465 (after accounting for a dividend tax credit of £3,385) without incurring any taxes. However, if he wishes to withdraw the maximum amount available, the remaining dividend payment of £7,455 will be taxed at an effective rate of 25%. This means there is an overall effective (cash) tax rate of 20.6% payable by company/ director on gross profits of £55,000.
Director’s drawings from company Tax credit Tax to pay
Dividend (at basic rate) £30,465 £3,385
Dividend (at higher rate) £7,455 £828 £1,864
Company’s corporation tax £9,480
Director’s income tax £1,864
Effective (cash) tax rate 20.6%
Everyone’s circumstances are obviously different, however, and professional advice should always be sought in order to consider all the wider ramifications of any particular business structure.