Extracting Value from a Business

One of the most commonly asked questions in practice comes from clients who own their own company, and want to know the most tax efficient way of taking money from the business.  It is also therefore a common topic for the exams. 

Most of the areas discussed in this article will apply to those sitting OMB Advisory and A&I but some can apply in other papers.

Firstly, let’s set the scene.  The client has set up a company, where he is the majority shareholder. His wife owns a minority stake.  She does not have a job as she is currently at home looking after the children.  One child is 17 and about to go off to university - the other is 15 and still at school.

The company is successful, generating reasonable profits on an annual basis. 

Next we have to consider what his cash needs are.  Does he need money to fund his living expenses or does he have income from other sources that could be used?  He may be looking to invest in assets such as property, shares etc to build a portfolio to fund his retirement.  On that point, does he have a pension, and what is the position with regard to its funding?

For most individuals the choice of how they extract value is between:

  • salary/fees
  • dividends
  • pension contributions
  • benefits in kind

Salary

This is probably the most straightforward method of taking funds from the company.  It should be paid through the payroll, with the relevant PAYE/NIC implications (including RTI). The cost of salary is increased as the company will have to fund not only the salary but also the employer’s Class 1 NIC at 13.8% on earnings over the secondary threshold. It is assumed that the Apprenticeship Levy is not due.

One of the advantages of taking salary is that it can be paid even if the company is not making profits, although the tax cost for both the company and the individual is relatively high compared with the other methods of extracting value.

As his wife has no other income they might consider paying her a salary.  However, if this is to be deductible for corporation tax purposes it must be reasonable for the work done.  If she does not perform any meaningful duties for the company then no deduction will be available.

If she is appointed as a director she could then be paid director’s fees, which depending on the amount paid could give her sufficient income to generate an NIC record allowing her to qualify for state pension in her own right.  The NIC cost should be negligible as it is unlikely they could justify fees much over the NIC threshold.

Dividend

Dividends do not attract an NIC liability, and the first £5,000 is taxed at nil. As a result dividends will normally create a lower tax cost for the shareholder than salary.  However, they are not corporation tax deductible.

A key point is that dividends can only be paid if the company has distributable profits.  In addition, they must be paid to all shareholders and so there is less flexibility.  It is possible to waive a dividend but the procedures for doing so are complex, and many clients will get it wrong.

It is possible for the two shareholders to have ‘A’ and ‘B’ ordinary shares.  In this case, different levels of dividend can be paid providing no shareholder receives more than they could if both shareholders took the full amount.  

For example, if the husband and wife owned 100 A shares and 100 B shares respectively, and the company made a distributable profit of £100,000 the maximum dividend would be £500 per share (£100,000/200).  The company could therefore pay different dividends on the ‘A’ and ‘B’ shares, providing neither shareholder received more than £500 per share.

If the wife (in this case) is to be paid dividends the shares she owns must have the same rights as her husband’s shares otherwise the settlements provision could come into play, meaning the dividend income is taxable on the husband.  The rights to be considered are the right to vote, participation in profits, and a share of the net assets if the company is wound up.

The main issue with dividends arises with the legal side of the process.  This is especially important where the company has no retained profits from earlier years.  HMRC will expect there to be evidence of the company preparing accounts to demonstrate there are sufficient profits to support the dividend payment.  This must be done every time a dividend is paid. 

Furthermore, it is necessary to differentiate between an interim dividend and a final dividend.  An interim can be approved by the directors but a final dividend must be approved by the shareholders.

HMRC will consider whether the relevant paperwork – minutes, dividend warrants etc - is in place to back up the dividend.  If not they may well contend that this is a loan – probably with s455 implications – see below.

Salary v dividend

As a rule of thumb, the tax cost of paying dividends is lower than the payment of a salary – see Illustration 1.

Illustration 1

 

 

 

Assume a company has profits of £50,000 (before CT) which it can use to pay a bonus or a dividend.  The company pays CT at 19%, and the individual pays tax at 40% on their existing salary.

Position of company

Salary
£

Dividend
£

Profit available

50,000

50,000

Employer’s NIC  13.8/113.8 x £50,000

 (6,063)

 

Salary

43,937

 

 

nil

 

CT at 19%

nil

(9,500)

 

nil

40,500

Dividend

 

(40,500)

Retained

nil

nil

 

 

 

Position of shareholder

 

 

Salary received

43,937

 

NIC – 2%

    (879)

 

IT – 40%

(17,575)

 

Net receipt

25,483

 

Dividend received

 

40,500

Tax at 25% on £(40,500 - 5,000)

 

 8,875

Net receipt

 

31,625

Total tax cost (company and individual)

24,517

18,375

Effective tax rate

49%

  37%

The assumption here was that the individual was already receiving a reasonable salary – enough to mean their earnings for NIC were in excess of the upper threshold.

In many cases director/shareholders extract the major element of the profits by dividend but they should always pay a salary up to the NIC threshold to ensure their record is franked for the purposes of the entitlement to state pension. The remainder can then be taken as dividend.

Pension contributions

Where the individual has sufficient income to fund their living expenses they may consider pension contributions to fund their retirement.  It should be remembered that money put into the pension scheme cannot be accessed until the age of 55 so this is not a suitable use of funds if the money may be needed before then to fund the children’s education, buy investments, or fund a holiday home for example.

The contributions should be made by the company as it does not make sense for the individual to do it if they would need to extract profits to do so, which could trigger  an NIC cost.

The maximum a company can contribute to the fund is currently £40,000 a year.  However, if the company has not been funding at the maximum level in earlier years there is an ability to bring forward the unused amount from the previous three years.  If contributions are made in excess of the limit, the individual will be liable to the annual allowance charge on the excess at their top rate of tax.

It should be remembered that corporation tax relief is available when the contributions are paid not when they are accrued in the accounts. The spreading provisions are unlikely to be in point for an SME, as the contributions in any one year are unlikely to be large enough to trigger the provisions.

Benefits in kind

There are some benefits that are exempt, such as the mobile phone, childcare vouchers, and pension contributions that can be used.

Previously, for other assets it would be necessary to compare the cost of providing the benefit personally from the individual’s after tax income or buying it through the company and having it included on the P11D.  In many cases the company route was cheaper. 

With the introduction of the rules on Optional Remuneration Arrangements this may no longer be an attractive proposition other than for the benefits above which do not fall within the rules - especially pensions and childcare.

Directors’ current accounts

The incorrect operation of a current account can be expensive from a tax and penalties perspective, and they are commonly misunderstood by clients, especially where the business was previously run through an unincorporated structure where money could be drawn with no tax implications.

The rules are different depending on whether the current account is to be credited with salary or dividends.

If it is salary, any debit to the account when it is overdrawn should be processed through the payroll.  This follows the basic rule that director’s earnings are taxed at the earlier of when they are received or when they are earned.  A debit to the current account means they have been received.

When the salary for the year is then credited, any amounts not already charged should also be payrolled, and can then be withdrawn without a further tax charge.  Once the account becomes overdrawn the amounts debited start to again become liable to income tax and NIC and PAYE should be operated.

Where this is not being operated correctly, the tax is being deducted and paid over later than it should be, giving interest on late paid tax.  In addition penalties will apply and under RTI it is likely that the reporting is also not being completed at the appropriate time and so further penalties can apply.  A potentially very expensive mistake overall.

Where the account is to be credited with a dividend the key is to consider the s455 charges – which can apply where a close company makes a loan to a participator – in this case our director/shareholder.

The company will be liable to make a payment under s455 based on the balance of the loan account at the end of the accounting period or the date the corporation tax is payable, whichever is the lower.  It is important therefore, to ensure the dividend is correctly declared and credited into the accounts by the due date for the corporation tax, which in most cases will be nine months and one day after the end of the accounting period.

If this deadline is not met the company will have to pay the s455 charge, which can then only be recovered by deducting it from any corporation tax payable for the period in which the repayment is made (or the loan written-off).

The timing is therefore crucial to avoid the negative impact on the company’s cash flow.

Summary

So overall, the position is quite complex, depending on what the taxpayer decides to do with regard to their requirement for cash.  HMRC are keen to ensure that whichever way the profits are taken the ‘i’s are dotted and the ‘t’s’ are crossed.   The position on penalties and interest means that it is crucial it is done properly – and the main aspect of this is educating the client in what they can and cannot do in this context.

Marion Hodgkiss
Head of Tax, Kaplan Financial