A sole trader, partner or company director takes on the responsibility and risks involved with running a business as well as ensuring the business produces a profit and they will want to be rewarded in the most tax efficient manner. There are a number of different ways to extract funds from the business, and the optimum method of extraction with the minimal amount of tax being paid by both the individual and the company will depend upon the individual’s circumstances and requirements.

It is not unusual for directors to also be shareholders of the business. This will give them the flexibility of extracting cash from the business by way of salary, dividend or a combination of both.

Salary

Directors will normally pay themselves a salary out of the company. At a minimum it is advisable to pay any salary up to the Lower Earnings Limit (LEL) for NIC in order to qualify for state benefits. The LEL is £6,032 per annum (2018/19).

An individual will not pay any income tax if their salary is less than the personal allowance (£11,850 for 2018/19). However Employees’ and Employers’ NIC is payable when the salary is greater than the Primary Earnings Threshold (PET) of £8,424 per annum (2018/19).

If the Employment Allowance (EA) is available, it would be beneficial for the company to pay the director a salary up to their personal allowance. While Employer and Employee’s NIC would be payable, no income tax liability will arise. From 6 April 2016, limited companies where the director is the only employee paid earnings above the Secondary Threshold for Class 1 National Insurance contributions are no longer be able to claim EA.

If the company is not claiming the EA, £8,424 is the most tax-efficient salary to draw in 2018/19.

Bonuses

Bonuses are also subject to income tax and national insurance. Directors may be able to receive a bonus even if the company is loss making with no retained earnings. The amount of a bonus that could be paid will invariably depend on the company’s results from the previous year.

Where directors are involved in the company’s Research and Development (R&D) activity it may be worthwhile paying a bonus on top of their normal salary as these costs also qualify for the enhanced R&D tax relief, as dividends are not a qualifying costs for the purposes of R&D tax relief.

Salaries and bonuses are also tax deductible in calculating corporation tax saving corporation tax at 19% (Financial Year 2018) on the gross salary plus employer’s NIC.

Paying a salary to a spouse/other family members

Employing family members or spouses can be a useful way of spreading the tax burden within a family run business and obtaining a tax deduction at the same time. The salary paid must reflect the work actually carried out. The salary should be paid into the individual’s bank account and recorded in accordance with the rules and regulations of Real Time Information for payroll schemes.

Dividends

In most circumstances, dividends continue to be more tax efficient than paying bonuses and are an effective reward paid to shareholders. For dividends to be paid to shareholders lawfully the company must have sufficient profits and distributable reserves and be paid in proportion to the shares held by each shareholder of each class of share.

The rules for calculating income tax on dividends have changed substantially in recent years. From 2018/19 the first £2,000 of dividend income is taxed at 0% and in excess of this will be taxed at 7.5%, 32.5% and 38.1% depending on the individual’s income level.

If there are insufficient profits but a distribution is made, the shareholding director may be liable to repay the dividend. They may also find themselves in breach of their duty of trust and may be personally liable.

It is also worth remembering dividends are not subject to NIC.

Use of home as office

Many individuals use their homes as a working base for their business. Under HRMC guidance, directors may claim £4 per week as home working expenses to cover the extra cost incurred in relation to the cost of gas and electricity used for business use.

For sole traders, use of home is usually a more generous claim. Sole traders have the advantage of claiming a percentage of costs such as rent, council tax, mortgage interest, water rates, heating, electricity and home insurance.

It is also worth noting that if a room in the sole traders or directors’ house is given sole business use this could restrict the availability of the capital gains tax Private Residence relief when the property is sold.

Pensions

Setting up a pension plan can be a tax efficient way to get money out of the business while also investing in the longer term financial security of an individual.

One of the main incentives for investing in a pension scheme is the income tax relief available. Tax relief on pension contributions made by an individual into a qualifying pension scheme is limited to the higher of 100% of their relevant UK earnings or £3,600 per annum. Dividends do not qualify as net relevant earning and therefore restrict the amount that can be paid into the scheme.

Individuals making personal pension contributions into a qualifying scheme will usually get 20% tax relief in the form of this being added to the pension by the government and in addition will get income tax relief through their personal tax return if earnings are above the basic tax band.

The company may be able to make a contribution into the pension scheme on a director’s behalf. The employer contributions are considered to be “a business expense” and are therefore tax deductible, subject to the spreading provisions and the wholly and exclusively test.

There is also no Employee or Employer’s NIC due and no tax liability charged on the director up to the Annual Allowance threshold (£40,000 for 2018/19) with a lifetime allowance of £1.03 million. Where income is greater than £150,000, the annual allowance is reduced by £1 for every £2 of income over £150,000 to a minimum of £10,000. Any unused allowance can also be carried forward for up to three years.

For sole traders the rules are slightly different. The net relevant earnings are based on profits for the year. Pension contributions are not classified as a business cost and will not affect self-employed profits.

It is always best to engage with a Pension Advisor before making any payments into a scheme.

Benefits

Director’s withdrawals from a company need not be in the form of cash, they may be in the form of a benefit in kind such as cars, fuel, medical insurance etc. Companies pay for the benefit, receive the tax relief on the purchase and the director will receive the benefit without the financial expense personally. There may be Employers NIC at 13.8% due on the benefits in kind and they will need to be reported on a P11d form.

Company cars may not always be the most tax efficient for the director. Tax and NIC will be due on the benefit which will be paid by the director although this can be reduced by choosing a low CO2 emission vehicle.

The fuel benefit charge will arise where a business pays for all fuel whether it is for business or private use. This can prove to be an expensive benefit. An alternative method would be for the director to pay for all fuel and to keep a mileage record of business miles done and claim the expense back from the company.

Company vans may be a cheaper option than company cars. Several models such as the SUV type 4x4 pickups qualify as a van but have the sophistication of a car. It is also worth noting if the private use of a van is insignificant the benefit can be reduced to nil.

Directors loan accounts

This is a popular method of borrowing funds from the company, especially if there are difficulties in obtaining finance from lenders.

The loan must be repaid within nine months and 1 day after the end of the accounting period in which it arose. If it remains unpaid at that date, the company will be liable to an additional 32.5% tax charge (called the section 455 charge). If the loan is repaid, repayment of the section 455 tax can then be reclaimed.

If the total amount of the loan outstanding is above £10,000 at any point during the tax year, the director is also considered to have a benefit in kind from his employer. The taxable amount on this benefit will be calculated and reported on a P11d form on behalf of the director and the company will pay NIC on providing the benefit. There is no Employee NIC due on the loan.

Conclusion

Extracting funds from a business can be very complex. Depending on the personal needs of the individual, it is also worth considering the impact the extraction of funds will have on child benefit. If cash extraction is increased above £50,000, it may result in a tax charge, and for those earning over £60,000 it may be advisable to no longer claim the benefit. With the right guidance and planning, all of the above can be set up easily and in a tax efficient way that is beneficial to both the individual and the business.

Paula Gallagher is a Senior Associate with Cavanagh Kelly.

Email: Paula.Gallagher@cavanaghkelly.com