You have profits in your limited company, great. How do we get those profits out of your limited company the most tax efficient way?
‘Profit extraction’ is a pretty clinical phrase to describe one of the most exciting aspects of being your own boss: getting paid for all the hard work you’ve done building your business.
When you’re a sole trader, it’s all fairly straightforward. You are the business, and the business is you. That means any money the business makes over and above the cost of running it can go straight into your pocket – less anything you’ll owe in income tax and National Insurance contributions (NICs), of course.
When things get more complicated is when you decide to set up a limited company, otherwise known as incorporation. When you do that, you become a limited company director and have some choices to make about how you go about getting paid.
A common mistake made by many first-time limited company directors is to pay themselves entirely in the form of salary. On the surface, it makes sense: directors are employees, and salary is how most employees are paid.
Simple though it may be, however, you’ll probably end up paying more income tax.
You’ll also have to pay NICs as both an employee and, through the limited company, as your own employer.
But don’t worry, there are smarter options available which can reduce your tax liability considerably.
The 4 most common ways of taking money out of your limited company
Salary plus dividends
First, let’s be clear: you don’t want to do away with salary altogether.
In the 2021/22 tax year, you can earn up to £12,570 before you’ll have to pay any income tax at all.
To protect your entitlement to a state pension, which is by no means large but offers a guaranteed minimum income when you retire, we recommend that you draw a salary that is equal to the ‘Primary Threshold’ which is £8,840 per annum for the 2021-22 tax year.
At this rate, you’ll qualify for the state pension but won’t attract any extra employer national insurance contributions.
That’s hardly the kind of money you expect to be earning given all the extra effort that goes into running your own business, though, so how do you make it up to something more reasonable? One answer is through dividends.
Dividends are payments made to shareholders and directors from their annual profits. Assuming your limited company has made a profit, you can take up to £2,000 in dividends without paying income tax on them.
Thereafter, any additional dividends you take are taxed but at a much lower rate than the income tax, you’d pay on the equivalent salary.
In 2021/22, basic-rate taxpayers (those earning up to £50,270 including the personal allowance) pay income tax at 20% on up to £37,700 in income.
Meanwhile, the tax on dividends for those in the same band is only 7.5% – quite a difference.
|Income Tax in England, Wales and Northern Ireland 2021-22||Dividend Tax 2021-22|
|Up to £12,570 (your personal allowance)||0%||Up to £2,000 (your dividend allowance)||0%|
|Basic rate £12,571 – £50,270||20%||Basic rate £2,001 – £37,700||7.5%|
|Higher rate £50,271 – £150,000||40%||Higher rate £37,701 – £150,000||32.5%|
|Additional rate £150,001+||45%||Additional rate £150,001+||38.1%|
Your personal allowance is reduced by £1 for every £2 you earn over £100,000, which means if you earn over £125,140 you receive no personal allowance.
When deciding the exact salary and dividend mix for you, you also need to consider other sources of income that you may already have that will affect the taxes you pay.
If you have savings, shares, investment properties etc, your total income will be assessed for tax including these other sources, which will ultimately decide the tax rate you’ll be paying.
It may be an option to introduce your spouse into the business if they have no other sources of income, as you will maximise the drawdowns available and use their tax-free personal allowance which would otherwise go unused.
Don’t overlook pension contributions
Although the dividend-salary mix is still a good way to achieve tax efficiency, it’s not quite as effective as it was a few years ago in the days of the 10% dividend tax credit.
That’s why increasingly people are also throwing pension contributions into the blend.
The annual pension allowance for 2021/22 is £40,000. If your company makes contributions into your pension up to that amount this year, no income tax would be due. Income tax, however, might be due at your marginal rate when the time comes to receive income from your pension.
Through a separate allowance, you can also build up a pension pot of £1,073,100 (until 5 April 2026) over the course of your lifetime.
Of course, paying into a pension isn’t quite as much fun as money you can access right now to pay for holidays, new cars, vintage electric guitars or whatever floats your boat.
You’ll certainly be glad of it later in life, though, and your money is better off there than with the taxman.
Any cost that you have personally incurred on behalf of your business and is ‘wholly and exclusively for the purpose of your business can be claimed as a legitimate business cost. Not only will those expenses reduce your limited company’s taxable profits, and therefore its tax bill, you will also be able to reimburse yourself personally for the cost.
These costs typically include mileage for business purposes, insurance, other travel expenses and even equipment, but can include any cost which was necessary.
Although these costs typically won’t make up a large proportion of the money you can legally take out of your limited company, this is an additional and tax-free method which many directors find useful.
Fund tax efficient investments with profit extraction
If after you’ve exhausted all other options, you’re still looking for other methods of tax efficient extraction, you may want to consider certain tax efficient investments.
Both have tax saving benefits, with VCT being more suited for profit extraction as it provides 30% income tax relief (it reduces your personal tax bill) as well as paying out tax free dividends. EIS is a longer-term strategy that has capital gains and inheritance tax advantages.
VCTs (and EIS) are high risk investments, with very strict qualifying criteria and with minimum holding periods, however, they are worth considering for those who can afford to do so and where pension planning has been maximised or where contribution limits have been reached.
What the right fit for profit extraction for you will come down too many factors and external influences, including other assets and incomes you have, future business succession plans and your own personal and family objectives. These will all influence what the best overall approach is.
You should seek the advice of your trusted professional advisers who will be able to provide you with the optimal outcome.