Profits extraction from company
For one person companies, the most tax efficient method for extracting profits from a company is typically via a mixture of salary and dividends.
On the basis that the company owner has no other income, a personal allowance should be available in full. In this case, any salary paid which is below the personal allowance will not be taxable in the hands of the director. Director's salary can be deducted from profits for the purposes of corporation tax. A salary which is paid up to the level of the secondary threshold for national insurance purposes, while marginally less than the personal allowance, will not give rise to any national insurance liability.
Dividends paid to the company shareholders will have a non-refundable tax credit of 10%. Consequently, there is no income tax to pay on dividends which are within the basic rate band. However, to the extent that dividends increase total income into higher rate of tax there would be an additional income tax liability.
The effective higher rate tax on dividends is currently 25%. Since dividends are a distribution of post-tax profits, the combined effect of corporation tax and income tax on higher rate taxation is 40%. The combined rate of tax is 20% (corporation tax) 80% of 25% (income tax.)
Tax planning options
Within a one person company, the shareholder has discretion to delay withdrawal of profits.
To the extent that funds withdrawn from the company in a tax year are less than the available basic rate, a further dividend at the year-end can be proposed. A proposed dividend can fully use the available basic rate for the tax year, and reduce the reserves of profits which would otherwise be withdrawn as dividend in a later year and potentially taxed at a higher rate.
Dividends must be paid out of accumulated profits. Therefore, it is not possible to pay a greater amount in dividends than the company has earned in profits, even if the shareholder has unused basic rate.
Where profits exceed the available basic rate of the company owner, the shareholder can delay paying income tax by retaining profits in the company. Furthermore, if the profits of a future year dip below the basic rate band, accumulated profits can be withdrawn without giving rise to income tax.
Accumulated profits may be paid to other shareholders. While this saves tax, a shareholder is entitled to be paid dividends declared in their favour. Consequently, this arrangement would only be practical where the income producer for the company is prepared to divide income with another person. The arrangement is rarely suitable unless both shareholders are also spouses.
Where a company with substantial accumulated profits is no longer required, it could be dissolved. The extraction of net assets from the company would be treated as a distribution on winding up of the company. In most cases, a one-person company would be entitled to entrepreneur's relief and therefore profits would be taxed at 10%. A capital distribution taxed at 10% is lower than a dividend taxed at 25%. Factoring the effect of taxation, the combined corporation tax and income tax of a higher rate dividend is 40% (or 20% plus 80% of 25%), where the combined corporation tax and capital gains tax of a capital distribution is 28% (or 20% plus 80% of 10%.)
If the distributions of accumulated profits on winding up of the company exceed £25,000 then the transaction requires a formal liquidation. The resultant requirement for an insolvency practitioner would increase the costs related to the above arrangement.
In practice a shareholder can withdraw funds from the company at their own discretion. The first withdrawal of profits would be treated as a salary and reported to HMRC via the Real Time Information PAYE reporting system. Both salary and dividends are disclosed on the financial accounts reported to HMRC and both salary and dividends are included in the personal tax return of the shareholder director.
Provided there is sufficient income in the company at the year end to meet corporation tax, currently 20%, there are typically no further restrictions on the amount that a shareholder director can withdraw or the timing of such withdrawals.
Coman & Co have extensive experience in managing contractor companies and advising on director remuneration. Please arrange a free, initial consultation to discuss your requirements