What is the most tax-efficient way to extract business profits?
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I am the Managing Director of a small business and have been able to continue to operate during the pandemic. It looks like our 2020/21 profit will break all records. I pay myself within the basic rate tax band and then pay dividends, giving me about £55,000 per year. I don’t need additional income but I do need to take some of the profit out of the business. Can you suggest how I can do this without paying more tax?
Richard Barker of Smith & Pinching responds:
We talk to lots of business owners about the most tax-efficient way to extract profits from a business: the solution of paying yourself a low salary and dividends is a common one. If you are a basic rate taxpayer, the rate of tax on dividends (just 7.5pc on anything over your dividend allowance of £2,000) certainly makes them attractive when compared to income taxed at the standard rates of income tax.
One way to extract profits from your business would be to make additional contributions to your pension. This is tax-efficient for both you and the business. However, the total amount (employer and personal contributions combined) that can be contributed to your pension is limited by the annual allowance, which stands at £40,000 for most people.
There is also a limit on tax-relievable personal contributions of 100pc of your earnings or £3,600 if more: a low salary will limit your opportunity to make personal tax-efficient pension contributions. You may be able to utilise a funding strategy known as carry-forward if you have unused annual allowance from previous tax years. The annual allowance is reduced for those with particularly high earnings or those who have started taking flexible benefits from their pension, but presumably neither factor applies in your case.
The good news for your company is that any contributions made by the business into your pension fund can normally be counted as a deductible expense for corporation tax purposes providing such contributions meet the ‘wholly and exclusively’ rule. In addition, where paid as an alternative to salary/bonus, the contributions reduce the figure used to work out your Employer’s National Insurance contribution.
A strategy using pension contributions should be considered from your own financial perspective, too. You get tax relief on your contributions, so paying a larger amount from your salary will reduce your own tax liabilities. It’s also important to have a plan in place to ensure you are saving enough in your pensions to achieve your desired lifestyle in retirement.
I think it would be helpful for you to have a financial review with a Chartered Financial Planner to enable you to find the right balance of salary, dividends and pension contributions that will benefit you and your business.
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Any opinions expressed in this article do not constitute advice. They assume the 2021/22 tax year and may be subject to change.
For more information, please visit www.smith-pinching.co.uk