How can you tax-efficiently extract your profits
If you operate your business as a personal or family-run, you will have to extract some or all of the profits for personal use. In terms of tax, not all profit extraction methods are the same and personal circumstances usually dictate the most efficient way for you. However, the following methods should be included as part of a tax-efficient extraction strategy.
Paying a small salary can be tax-efficient if the recipient hasn’t used their personal allowance elsewhere. Paying a salary that is at least equal to the lower earnings limit for National Insurance purposes (£6,396 set for the year 2022-2023), will ensure that the tax year is a qualifying year for state pension purposes. This is useful when the recipient does not already have the 35 qualifying years needed for a full state pension.
For the year 2022-2023, the optimal salary will depend on whether the National Insurance Employment Allowance is available to shelter any employer’s National Insurance on the salary. When the personal allowance remains available in full, the optimal salary where the Employment Allowance is not available (for example if the sole employee is also a director), is one equal to the primary threshold of £11,908. If the Employment Allowance is available (or one of the higher secondary Class 1 National Insurance thresholds applies), the optimal salary is one equal to the personal allowance, set at £12,570 (again, for the year 2022-2023).
Dividends are paid from post-tax profits, which have already suffered corporation tax. All taxpayers benefit from a dividend allowance of £2,000 (for the year 2022-2023). If this remains available, paying a dividend up to this amount allows profits to be extracted free of any further tax.
Once the optimal salary has been paid and the dividend allowance has been used, if other profits are needed outside the company, it is generally preferable to take dividends rather than an additional salary as the dividend tax rates are lower. There is no National Insurance to pay on dividends.
Remember that dividends must be paid in proportion to shareholdings and only be paid if you have sufficient retained profits from which to pay them. Using an alphabet share structure preserves flexibility.
Many personal or family companies are home-based. The company can rent a room from the director and pay rent for the privilege. This is tax efficient, as the company benefits from a deduction for the rent paid when calculating its profits for corporation tax purposes. While the rent is taxable in the hands of the director, if the director does not have other rental income, he or she may be able to benefit from the property income allowance to receive £1,000 of rent tax-free as well as no National Insurance tax.
The company can also make pension contributions on behalf of the director or their family. The company usually is able to deduct the pension contributions in full when calculating its profits. If contributions don’t exceed the available annual allowance or take total tax-relieved contributions above the level of the lifetime allowance, there will be no tax charges on the recipient.
It can be tax-efficient to provide directors and family employees with exempt benefits in kind, such as a mobile phone or workplace parking, as the recipient will enjoy the benefit tax-free, while the company can deduct the cost in calculating its taxable profit. Where an exemption applies, there is no Class 1A National Insurance for the company, and most benefits in kind are free of employee National Insurance.
Benefits-in-kind can still be tax efficient even if a tax charge applies. For example, it may be beneficial for the employee to have an electric company car rather than be given a higher salary to fund the car. Providing a benefit rather than an additional salary will also save employees’ National Insurance as most benefits-in-kind are liable to Class 1A (employer-only) rather than Class 1.