Claire Trott: Extracting company profits with maximum efficiency

Extracting profit from a company at the end of the tax year is a process with many moving parts, writes Claire Trott. Here she explores the three options available

Extracting profit from a company at the end of the tax year is a process with many moving parts, writes Claire Trott. Here she explores the three options available

As we approach the tax year-end there will be companies that have made a profit this year and will want to extract these profits in the most tax-efficient way. There are three options available: take more salary, pay extra pension contributions, or pay a dividend.

There are various issues to consider with regards to the numbers, but as we know, it isn’t always about the figures as it can also be about personal preference. All clients are different, and their wants and needs must also be considered.

NI contributions

National Insurance (NI) contributions are paid on an employee’s salary, at a rate of 13.8% employer NI and a further 2% employee NI, or 12% if their salary is below the upper earnings limit.

This is the biggest hit that payments could receive. For example, £20,000 would suffer £2,425 employer NI. The residual would then suffer a further £2,109, if below the upper earnings limit, and that is even without income tax. If above the upper earnings limit however, the employee NI would be only £351.50.

Corporation tax

Salary and pension contributions would generally be classed as allowable business expenses and therefore would reduce the amount of corporation tax payable. This means that the whole amount can be used as the starting point for the payment. On the other hand, dividends are not a business expense and will be subject to corporation tax. With corporation tax at 19% this would reduce the payment made by £3,800.

Income tax

Pension contributions are not taxed immediately but will eventually be subject to income tax at the client’s marginal rate, although in most cases 25% will be paid tax-free. Growth is also generated tax-free within the pension, which could increase the eventual tax paid or even subject the payment to a lifetime allowance charge.

The salary will be subject to the client’s marginal rates of income tax. When the client is earning at or near £100,000, care really needs to be taken as the loss of the personal allowance could make this option less attractive. In our example, we have assumed that the whole amount will be within the higher rate band, so it is subject to 40% tax.

The same is true of dividends although the client may also have access to the dividend allowance of £2,000 depending on other dividends received. In our example, we have assumed that this payment is in addition to dividends already taken, which has used the allowance. The higher rate tax on dividends is less than on salary at only 32.5%.

Inheritance Tax (IHT)

Although not an immediate tax, payments made to pensions should remain outside the client’s estate for inheritance tax purposes. If the client already has an IHT issue and doesn’t need the income, then taking dividends or salary just to invest will only add to the issue.

Annual allowance issues

For many, the tapered annual allowance won’t be an issue, but for those whom it concerns – including those that have already utilised their standard annual allowance – this will need to be considered. The benefit of tax relief will be lost on anything over the client’s available annual allowance and carry forward, which may mean that a pension contribution is less favourable. The annual allowance can’t be ignored but it shouldn’t be the sole driver for dismissing pension contributions as an option.

Access

We shouldn’t forget that pensions are a long-term investment, as I was reminded this morning – you can’t buy groceries with a pension contribution. Well, you can but not until you are over 55, which may be a little late if you are hungry. So, although it can be relatively easy to justify a pension contribution on the numbers alone, holistic planning requires a deeper understanding of clients’ circumstances.

Extracting funds from a company has many moving parts. In reality, some if not all the three routes will be used each year to maximise the use of allowances and provide a useable income and protection for the future.

Example for a company with £20,000 to distribute

 

Salary

Dividend

Pension contribution

Employers NI

£2,425

Corporation tax

£3,800

Cost to company

£20,000

£20,000

£20,000

Residual amount

£17,575

£16,200

£20,000

Immediate Income tax

£7,030

£5,265

Employee National Insurance

£351.50

Amount paid

£10,193.50

£10,935

£20,000

Income tax if drawn from pension *

£6,000

Net benefit £10,193.50 £10,935 £14,000

*assuming income tax rates remain the same, 25% tax-free cash is taken and residual taxed at 40%

Claire Trott is head of pensions strategy at St. James’s Place Group