The ABC of Profit Extraction
The subject of this article is probably the one most frequently faced problem in the whole of tax planning: how to minimise the tax you pay on profits you take out of your business.
This problem is completely different, depending on whether you are running your business through a limited company or through some other vehicle, but as the limited company is by far the most commonly found business entity, I am going to assume, in what follows, that this is the situation the reader is in. Although I have called it the “ABC of profit extraction”, which suggests a basic survey, I may just throw in the odd swerve ball as well!
The Basic Problem
So here’s the situation you’re in. Your company has traded profitably – whether in the current period or in the past periods doesn’t matter. You can see all that lovely lolly sitting in the company bank account and, not surprisingly, you would like some of that in your personal bank account, so that you can spend it on having some kind of life, or perhaps building up a personal asset portfolio for your retirement. There’s no point running a profitable trade if you can’t enjoy the fruits of your labour.
Apart from pensions, which I won’t be dealing with in this article, I’ve identified seven different ways you could do this. There are others, but most of them involve major surgery on your business structure, and are definitely outside the scope of the phrase “ABC”.
All of these different methods of extracting profits from the company involve different tax liabilities. So let’s have a look at them.
By “remuneration”, I mean anything like wages, salaries, bonuses etc, that are taxed by the Revenue as employment income. This article is really addressed to the owner managers of a private company, so I am going to assume that you are both director and shareholder of your company, and can choose to take out the profits in whatever way suits you. Providing the amount of remuneration you pay yourself, as director or employee of your company, is a reasonable amount by reference to your services to the company, the first point to make is that this remuneration will be treated as an allowable deduction against the corporation tax liability of the company. So there’s no corporation tax, effectively, on the company profits, to the extent that you pay them out to yourself as remuneration.
Instead, of course, there’s income tax at whatever your marginal rate is. This will be 20% if your total income is no more than about £42,000, 40% above that figure, and 50% above £150,000 of taxable income.
So whatever else it is, the remuneration route isn’t a low cost option. You pay full income tax on the amount you get out, in common, indeed, with most (but not all) of the profit extraction methods I’ll be considering.
In the case of remuneration, though, there is a further “sting in the tail”, which in my view makes it unlikely that remuneration will ever be the clear winner in our “beauty contest” of profit extraction methods.
This sting in the tail, of course, is national insurance. Personally I feel it’s high time that the government gave up the hypocritical pretence that national insurance is any kind of insurance policy. It’s really an additional tax, and this description applies particularly to the so called employer’s national insurance contribution.
I say “so called”, because, as far as I am aware, employer’s national insurance contributions give rise to no entitlement to state benefits whatsoever. So calling it national insurance is seriously misleading. But from the point of view of our consideration of profit extraction, it’s clearly got to be regarded as exactly the same as an additional tax. At present, as I write, the rate of employer’s national insurance (above a low starting threshold) is 12.8%. We’re promised an increase from next April to 13.8%.
I won’t set out the sums in detail here, but if you are a 40% taxpayer, your total burden on extraction of profits including employer’s national insurance is currently in the region of 47%. (Not 52.8%, because the employer’s national insurance itself reduces the amount that can be paid to you as salary, and thereby subjected to tax at 40%.)
Just pausing to note that this is, of course, a higher rate than you would be paying if you were simply conducting your business as a sole trader, and paying 40% income tax and an effective 1% self-employed national insurance, I’ll move on quickly to the next profit extraction method, which is dividends.
At first sight, paying dividends out of your company would seem to solve this national insurance problem, in that dividends are in all normal circumstances treated as investment income and therefore don’t attract a national insurance liability. Again the sums are complicated and I won’t burden my type setter by setting them out. But take it from me that the taxation of profits extracted by way of dividends, subject to one very important point, is aimed at bringing about a total overall tax charge equal to your marginal rate. That is, if you are a 40% income taxpayer, profits taken out as dividends will pay both corporation tax and a supplementary income tax charge, the two adding up, in total, to 40%. If you’re a 50% taxpayer, the total will be 50%, and so on.
In some cases this is a bit of an approximation, but in tax planning terms the differences are likely to be too small to worry about.
The important point that I have reserved for further discussion, though, is that this does not apply where the company is making profits before dividends of more than £300,000, or, where you have a group, £300,000 divided by the number of active companies in the group.
If your profits exceed this figure before dividends, you will be in the so called “marginal rate” of corporation tax. This is quite a bit higher than the basic rate, in fact currently it’s nearly 9% higher.
If you’ve a marginal rate corporation taxpayer in your company or companies, dividends turn out, due to a quirk of the rules, to be no better than remuneration, or not much better. The total tax rate works out again in the region of 46% to 47%.
Dividends may still be better than remuneration, though, if you can spread the shares in your company amongst other family members such as spouses/partners, and children who have reached the age of majority. (It’s no good diverting dividends to younger children, as these just get taxed back on you.)
I think that interest is much under used as a profit extraction method. If, as often happens, you’ve financed your own company by way of director’s loan, there’s no reason at all why the company shouldn’t pay interest, at a fair commercial rate, on that loan. If it does, this becomes a method of profit extraction, effectively, by you as the loan creditor.
The tax treatment is like remuneration, in that the interest paid is an allowable deduction against the corporation tax, but unlike remuneration in that there is no national insurance charge.
So interest is definitely a better method of profit extraction than either remuneration or dividends, where the company profits before interest are in the marginal corporation tax rate, that is over £300,000 looked at on a group basis.
If you run your business through a company, but also own the premises from which the company trades, it’s a good idea from most tax points of view to hold the property outside the company. As you are both the property owner and the shareholder/director of the company (I assume), you’ve basically got a choice on whether to let the company occupy the premises rent free, or charge a rent. If you charge a rent of anything up to a fair market figure, this is another example of profit extraction like interest, which is allowable against corporation tax without the sting in the tail of national insurance.
And there’s one further advantage in paying rent as opposed to interest: unlike interest, there is no requirement for the company to deduct income tax at the basic rate from the payments it makes to you. In the case of interest, this is an administrative hassle (no more than that) but one that you could probably do without, particularly in the context of the small and possibly already over stretched accounts department.
I need to write the next warning in letters of blood, though: there is a major new problem with using rent as a profit extraction method, resulting from the way they have written the rules for capital gains tax entrepreneur’s relief.
You may be aware that sales of trading businesses and companies are eligible for a 10% capital gains tax rate, as against the 28% rate that would probably apply otherwise. As well as qualifying for 10% on the sale of the shares, if you were to sell the property at the same time (remember I am assuming that it is held separately from the company) you would also get the benefit of the 10% rate – providing you have not been charging rent for its use. So do be careful about how you set up these arrangements. You might wish you had incurred the employer’s national insurance by paying remuneration instead of rent, if it then means that you have nearly three times as much capital gains tax to pay at the end of the day!
This one is perhaps a bit of a swerve ball. The basic idea is quite simple: you arrange for the company to lend you the money, rather than taking it out as any form of income. OK, so the loaning of money from a private company is illegal, but it doesn’t seem that there is any effective sanction for breaking the law, in this particular instance.
What the taxman does about the situation is probably the only significant downside. A tax charge is levied on the company equal to 25% of the amount loaned.
As it happens, this 25% is equal to the amount of tax that a 40% taxpayer would pay if the amount were a dividend rather than a loan, that is if it were income.
But there are two important differences which arguably favour loans as against dividends:-
- In the case of loans, it’s is the company that pays the tax, not the individual; and
- If you are actually a 50% taxpayer, or would be if you took the amount as a dividend, the 25% tax charge is actually less than you would be paying as supplementary income tax on a dividend. For people who pay tax at this new top rate, the supplementary income tax is over 36%, meaning that you effectively save over 11% by taking the money as a loan rather than a dividend.
Arguably, the most final and radical method of all: you can get the company’s profits out by liquidating it.
On the face of it, this seems like a very good option indeed. If the company counts as a trading company for entrepreneur’s relief purposes, you’ll have no more than 10% to pay, because liquidation proceeds are subject to capital gains tax, with the availability of CGT reliefs such as entrepreneur’s relief, and are not liable to income tax. Watch out for these traps though:-
- If the company owns any valuable assets, of which goodwill can be one, it’s treated as disposing of these assets when you wind the company up. So one of the things the liquidator has to find is corporation tax on the chargeable “gains” treated as arising;
- Liquidation of a company can give your business a “bad press”;
- If your business is actually ongoing, you can, of course, form a new company to take over the business of the old company that you are winding up. But, do this too often, and the Revenue start getting more than a little hot under the collar. In fact, for technical reasons, there is a danger that liquidation purely for tax saving purposes could be subjected to income tax by the Revenue rather than capital gains tax, under a specialised set of anti-avoidance rules.
Selling Assets to the Company
Another way of extracting profits from the company at capital gains tax rates, rather than the generally higher income tax rates, is to sell an asset you have to the company. This might be a property that you own personally, or it may even be the goodwill of a business that you are putting into the company. Providing the price the company pays you is no higher than a fair market price, you will be within the CGT sphere, and the company can pay you, either now, or out of future profits, that price without you bearing any more than the relevant CGT rate. This rate might be as low as 10% if you are eligible for entrepreneur’s relief on the asset concerned.
Having gone through the seven most common and popular methods of profit extraction, it’s time for a bit of lateral thinking. Why, precisely, do you want to extract the profits and incur these income tax or CGT charges? If what you want to do is buy some kind of investment, like a property, for example, there is nothing stopping you actually acquiring this in the name of the company. That way you don’t need to incur any tax charge.
Buying investment assets in a company does, of course, bring into play all kind of other tax planning considerations, but this article is already quite large enough! Let’s leave it that one should always consider the option of spending the money, however you were going to spend it, in the company, rather than in your personal name. Particularly if you are a 50% taxpayer, this could leave you with an awful lot more money available to spend.
Of course, this wouldn’t be an Alan Pink article without some kind of subversive comment about the idea of trading through a company in the first place! My brief comment above, about how dividends and remuneration, at a 47%ish tax rate, are more expensive than simple trading as a sole trader, is what you might call a foretaste of a much fuller discussion as to how to make your profit extraction tax efficient by use of a sole trader, partnership, or LLP structure. There are methods by which, effectively, you can achieve profit extraction at basic rates, even as a higher rate personal taxpayer, by making use of the very different rules that apply to these other business vehicles. That’s not so much the subject of another article, as the subject of a whole series of further articles!