Ways to extract profits from a business
We are now well into the 2021/22 tax year and there will be many business owners thinking about how to extract the profits they make this year in the most tax-efficient way.
Everyone’s situation is different and there are many considerations, depending on personal needs. There is also a balance to be struck between extracting money and investing for the future.
Essentially though, there are three main routes for a business owner to extract profits from a business or their Ltd company.
Ways to extract profits from a business
- Pension contributions if below minimum pension age (although this is taking money from the company for future use)
The other alternative is to leave the profit in your company and take the proceeds from a subsequent sale. Although excessive spare funds can mean that Business Asset Disposal Relief on sale can be jeopardised.
No one likes making payments in tax or national insurance, but if you could do this in a way that gives you the most benefit then why would you not? Paying tax is not a bad thing if the end result is more money at the time you need it.
There were no increases to Income Tax or National Insurance in the March 2021 Budget. The tax allowances and exemptions are as follows:
Income Tax – The personal allowance increased to £12,570 for 2021/22, frozen to April 2026. The higher-rate threshold – the point at which you will start to pay 40% Income Tax – rose to £37,701 of taxable income or £50,271 of gross income.
Dividends – The dividend allowance remained at £2,000.
Personal pensions – There were no changes to personal pension tax relief, so most people can still get relief on pension contributions worth up to £40,000 a year. The lifetime allowance remains at £1,073,100 for 2021/22 frozen to April 2026.
Capital Gains Tax – The CGT annual exempt amount for individuals will stick at £12,300 until 2026.
Inheritance Tax – The IHT nil-rate band for 2021/22 remains at £325,000, frozen until 2026. The residence nil-rate band remains at £175,000. Frozen to April 2026.
There were however some tweaks to tax policies that business owners should consider when looking at profit extraction. These are outlined below along with some of the main considerations you should make before deciding on the best option for extracting profits from your business.
National Insurance contributions (NICs)
As NICs are paid both by the employer and employee, business owners who pay themselves as employees are in effect charged twice. Employer NICs are 13.8% on earnings above £170 a week and employee NIC is charged at 12% for earnings between £184.01 and £967 a week and 2% for earnings above £967 a week.
Corporation tax is simply a tax on the profits of an incorporated business. You can deduct the costs of running your business before profits are calculated, so employee salary payments (including to the business owner where they are also an employee), employer’s NI and pension contributions are allowable deductions.
Salary and pension contributions would therefore reduce the amount of Corporation Tax payable.
Dividends on the other hand are not a business expense and will be paid out of profits that have already suffered Corporation Tax.
The current rate of Corporation Tax is 19%. So, if there was £20,000 to distribute, this would reduce the payment made by £3,800 (19% of £20,000).
The rate of Corporation Tax will rise to 25% from April 2023 for businesses with profits of over £250,000 and there will be a marginal taper for profits between £50,000 and £250,000.
For businesses who will be subject to increased Corporation Tax from 2023, it might become more efficient to extract profits into a pension for some individuals. Whilst the most tax efficient solution, it may not be the most practical solution for all as those under 55 need an accessible source of income for living expenses.
Subject to limits, pension contributions are not taxed immediately, although future pension income will eventually be subject to Income Tax at your marginal rate – although in most cases 25% will be paid tax-free.
It must also be borne in mind that tax-efficient growth generated within the pension could increase the eventual tax paid, or subject it to a lifetime allowance charge.
Salary on the other hand will be subject to your marginal rates of Income Tax. If you are earning at or near £100,000, you will need to be careful, as the loss of the personal allowance could make this option less attractive. Any earnings above £100,000 will start to erode the personal tax allowance of £12,570 a year (a £1 reduction for each £2 of income above £100,000), in effect increasing the amount of tax you pay.
The same is true of dividends, although you may also have access to the dividend allowance of £2,000, depending on any other dividends you receive. Dividend tax rates are lower in all bands. The higher-rate tax on dividends is lower than on salary at only 32.5%.
Through the personal savings allowance, basic-rate taxpayers can continue to earn £1,000 of interest on savings before paying tax in 2021/22 although for individuals paying tax at the higher rate the allowance remains at £500.
Inheritance tax is a tax on the estate, including money, property and possessions of the deceased. The standard rate is 40% on any value of the estate which is above the nil-rate band. Any further drawing, such as dividend or salary, that is not spent will increase the estate and therefore the amount of IHT payable.
Pensions are usually outside the scope of IHT on death.
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As can be seen, there are a limited number of options when looking to extract profits from a business. Each option has its own particular tax and NI consequence for the business owner with their employer and employee “hats” on.
The above taxation information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change. The Financial Conduct Authority (FCA) does not regulate taxation advice.
The information was correct at time of publishing but may now be out of date.