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Taxes: How company owners can extract the most profit

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Most company owners understand the tax advantages of taking dividend payments over salary, especially when the lower-rate and personal allowance have been used up. But over the long term, dividend payments may not always be the most appropriate action.

One reason is that, although the tax rate on dividend income may be lower than that applied to salaries, it is not necessarily the lowest rate available. 

Capital gains tax, especially if entrepreneurs’ relief applies, can provide an effective tax rate as low as 10 per cent. 

So if your current income needs are met, it may be beneficial over the long term to retain surplus funds in the business, allow reserves to accumulate and take it as capital when you sell the company. As always, careful planning is required and ensuring your tax strategy is in line with your objectives is paramount for reaping the rewards you deserve.

Pension planning

Another factor that should be taken into account is pension planning. As retirement age approaches, channelling funds into pension contributions becomes more attractive for company owners, as current legislation allows a tax-free lump sum to be drawn once retirement age is reached. 

Even if retirement is a long way off, pension contributions can still be a tax-efficient way to shelter profits.

When directors should be paid in salary, not dividends

If the company undertakes research and development, it might be worth focusing on salary rather than dividends for directors who are actively involved in R&D work. 

Salary costs attributed to R&D work can be eligible for an enhanced deduction, at a rate of 25 per cent, against profits. 

To check whether your company might benefit from this incentive, the best port of call is contacting your tax adviser who will be able to provide further information on the research and development activities which are included in the eligibility criteria.

Spousal income tax allowance

Then there is the spouse’s personal income tax allowance. Often, a spouse will be a minority shareholder and receive dividends, but employing them and paying a salary to utilise their personal allowance can be more effective. 

If set appropriately, neither salary nor dividends will attract PAYE or NI. But unlike dividend payments, salary costs are deducted from profits and so reduce your corporation tax exposure.

It is worth considering other benefits that the family might enjoy, as it may be possible for the company to meet these costs as part of the director’s overall package. 

However, it is worth remembering that HMRC takes a close look at dividends and other benefits paid to family members. This is becoming an increasingly risky form of tax planning. It is important that the individuals concerned are sufficiently active in the company to justify their remuneration.

Aside from the tax implications, relying too heavily on dividend payments can throw up practical problems when applying for loans and insurances. Some mortgage providers will not recognise dividend income as part of an applicant’s relevant earnings, which can limit access to future borrowings. Similarly, providers of critical illness cover may base pay-outs on salary, not total income.

u2028In conclusion, when looking at profit extraction strategies, a number of factors have to be considered. Not least of these is your attitude to risk. 

HMRC is becoming increasingly aggressive in its pursuit of tax planning schemes that it considers to be artificial. Tax investigations are both stressful and disruptive. More and more business owners would rather pay a little more tax each year in order to avoid attracting HMRC scrutiny.

Richard Godmon is a partner at Menzies LLP.

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