Believe it or not, there are more than 4.7 million limited companies registered in the UK. This includes the 810,316 incorporations that signed up in 2020/21.
Only around 2m are actively trading. But, the number of new companies formed during the previous tax year was a 22% year-on-year increase.
Unsurprisingly, that percentage represented the highest number of incorporations on record. Surprisingly, this record high was reached during COVID-19.
Company directors need to work out the most tax-efficient ways to pay themselves. You must be smart about how you extract profit to avoid paying more tax than you need to.
There are three main routes for directors to extract profits from their own limited companies – salary, dividends and pension contributions. Usually, combining these three methods is the most tax-efficient approach to minimise your tax bill.
Corporation tax applies (at 19% in 2021/22) on any of your company’s taxable profits from its accounting period. The money you take out of the profits to pay yourself can potentially reduce your company’s corporation tax liability.
Pay yourself a small salary
If you have a limited company, it’s easy to forget that the money you earn doesn’t go into your personal bank account.
So, to get it into your pockets, consider paying yourself a basic salary. This is usually set just below certain thresholds for National Insurance contributions (NICs). The aim of this is to enjoy the benefits of paying NIC without actually suffering any.
For example, let’s say you pay yourself more than the lower-earning limit of £6,240 (2021/22). Doing this will accrue qualifying years towards your state pension.
While that’s a positive, paying yourself more than the Class 1 NICs secondary threshold (£8,840) would be a negative.
Companies will be liable for employers’ NICs at a rate of 13.8% on any earnings above that. If you pay yourself a penny less than £8,840 in 2021/22, your company avoids paying this jobs tax altogether.
The next payroll consideration is the personal allowance (£12,570 in 2021/22). The basic rate of income tax doesn’t apply until you exceed this threshold.
One other point to consider is that any salary you pay yourself will be treated as a business expense. This means it will reduce your taxable profit and lower the amount of corporation tax your company has to pay.
Taking dividends
Dividends are paid to an incorporated company’s shareholders out of post-corporation tax profits. Usually, a director will be one of those shareholders and quite often the sole shareholder.
Many directors pay themselves in a combination of salary and dividends. As dividends are drawn from profit, you need to show you have profit reserves available before issuing dividends.
If you cannot demonstrate that, HMRC could reclassify your dividends as salary. In this case you would almost certainly need to pay income tax and NICs on that.
Dividends are a different form of taxable income, and they are treated slightly differently in comparison to salary. The same income tax bands apply, but different dividend tax rates are associated with them.
The best way to illustrate how dividends are taxed is through an example. Let’s say you’re the sole shareholder. Your company has made post-tax profits of £29,570, and your accounting period runs parallel to the tax year.
You take £8,000 as salary in 2021/22 and £29,570 in dividends, £37,750 in total. The £2,000 dividend allowance makes £27,570 of your dividend potentially taxable. What’s left (£35,570) will exceed the personal allowance (£12,570).
Once the personal allowance is deducted, £23,000 of your dividends will be taxable at 7.5%. You will fall into the basic-rate income tax band. This would leave you with a tax bill of £1,725. The dividend would be taxed as the top slice of income.
Pension contributions
The single most tax-efficient way to extract profits from companies, is to make employer contributions towards your pension pot. However, this is not the most practical way.
These will reduce a companies liability to corporation tax, and they are not subject to NICs. But this does involve taking money out of the company for future use.
You can put up to £40,000 into your pension pot over the course of the tax year. There will be no tax due on this. Additionally, you are able to carry over any unused allowance from the last 3 tax years
The total amount you can save without incurring charges into your pension pot is currently capped at £1,073,100. This is due to what’s known as the ‘lifetime limit’.
If you stay under these thresholds, when the time comes to take your pension benefits 25% is normally tax-free. Currently, you can do this after the age of 55, but it is rising to 57 from April 2028.
The rest of your retirement income exceeds the personal allowance. This will be taxed at your marginal rate of income tax under the current rules.
There are various ways to go about extracting profits from your incorporated business. We recommend getting personal tax planning advice. This will always help you pay the least amount of tax legally possible.
Other tax-efficient tips
The main rate of UK corporation tax applies at 19% on your company’s profits. The goal is to reduce those profits as much as possible before being assessed. The easiest way to reduce your company’s corporation tax bill is to claim every business expense you’re entitled to.
There’s a long list of business expenses which you might be eligible for. You can claim for expenses with a dual purpose for business and personal use in certain circumstances as well.
The golden rule is to keep accurate records of these expenses. This will be beneficial if you want to claim tax relief on those costs to reduce your company’s year-end profits.
Taking advantage of the annual investment allowance is also a wise idea. This lets your company deduct investments in plant and machinery from taxable profit in full.
For example, if your company has profits of £500,000 and you spend £250,000 on plant and machinery. If this is done before 31 March 2023, the full amount of this can be deducted from your profits. This means only the £250,000 left would potentially be liable for corporation tax.
If you can pay your corporation tax bill early without harming the company’s cashflow, HMRC will pay you interest.
You have nine months and one day after your company’s year-end to settle your corporation tax liability. If you pay six months and 13 days after the start of your accounting period, you’ll get ‘credit interest’.
The UK’s corporation tax rate will increase from 19% to 25% from 1 April 2023. It’s worth getting used to extracting profits now will be time well spent.
If you have any questions on this article speak to us for corporate tax planning advice. Fill in the simple form below and we will be in touch soon.