For many small companies, the directors and shareholders are the same people. This provides a multitude of ways in which they can benefit from their ownership and leadership, typically through a mix of salary, dividends (if profitable), and benefits.
Unless ‘IR35’ applies, then directors are broadly free to distribute profits to shareholders as they see fit.
The right mix of salary, benefits and dividends will vary from taxpayer-to-taxpayer. Accountants can be guilty of ‘imposing’ a ‘one-size-fits-all’ model of low salary and anything else as dividends, reminding clients to avoid higher or additional rate brackets if possible.
While salaries attract national insurance when at a high enough level, dividends only suffer income tax when the tax-free allowances have been used up.
This is a common reason for directors to run a salary which does not exceed the levels at which national insurance becomes due and, in most circumstances, it will not attract income tax at that level. The threshold for 2017/18 is £157 weekly or, £8,060 annually, and known as the primary threshold.
While not incurring a national insurance cost for the taxpayer or the company, many of the benefits associated with national insurance will continue to accrue, providing the director is earning in excess of the lower earnings limit – £113 per week or £5,876 annually for 2017/18.
This creates a ‘golden zone’ where a salary between the lower earnings limit and primary threshold can preserve access to state benefits and pension rights without leading to national insurance being due.
Tax-efficiency isn’t everything
However, a salary in this bracket might not suit everyone. Tax relief is available on contributions to pension schemes but this is capped at the value of ‘earned income’, although with at least £3,600 available regardless. Salaries count towards ‘earned income’ but dividends do not, which can mean that tax relief is capped at contributions of £8,060 if a tax-efficient salary is sought.
The interaction between salary, dividends and corporation tax should not be forgotten. While salaries are deducted from profits in determining the company tax bill, dividends are not deductible, so do not bring the tax bill down.
Directors may need to bear in mind how dividends and salaries are interpreted by financial institutions. Advice should be sought by those looking for mortgages or loans, about the mix of earnings or dividends necessary to obtain the required lending.
Business owners often question whether they are subject to national minimum/living wage regulations, as their employees are. HMRC have advised that it is highly unlikely a director without an employment contract would be subject to the legislation.
Loans to the company should not be forgotten as a source of withdrawing funds. To varying extents, it is common for start-ups and small businesses to input cash or assets into companies and these amounts can be repaid. Unlike salary and dividends, which attract tax (and national insurance for salaries) in their own way, repayments on loans will stay off tax returns.
Alongside, or instead of the aforementioned, directors may decide to retain profits in their business. This will have the effect of increasing the assets in the business, meaning a potentially bigger pay-out on sale or liquidation of the company. HMRC afford a lower entrepreneurs’ relief tax rate to owner-managers who dispose of their interest in companies, subject to various conditions and a limit. This can provide a tax-efficient solution to business owners where funds are accumulated over the life of the company rather than fully paid out.
A key benefit available to directors is to contribute to pension schemes from the company. Subject to the parameters, no income tax or national insurance arises on contributions to pension schemes, and the contributions will be tax-saving for the company, providing the amounts are commensurate to the standing of the director.
On the point of commensurate remuneration or benefits, HMRC will only allow deductions when the costs are ‘wholly and exclusively for the purposes of trade’. This would mean that any salaries paid to family members or friends should match the quality and quantity of work of an equivalent, unconnected employee and not be simply to utilise tax-free allowances or lower tax brackets.
Similarly, HMRC has challenged what they refer to as ‘income-shifting’ – allocating shareholdings in a company to lower-earnings family or friends to use up allowances and basic-rate bands. This can be an efficient method to increase funds which can be extracted without incurring higher or additional rate brackets, but care needs to be taken not to fall foul of settlements rules.
As with employees, different types of benefits and expenses can be provided to directors to varying degrees of tax-efficiency, from being tax-free, right through to where eye-watering tax charges arise. These could take many forms, such as mobile phones, company vehicles, travel and subsistence allowances and low-interest loans. A professional advisor will assist in ensuring a tax-efficient package is achieved.
Directors loan accounts
Some directors, particularly those accumulating funds in a business, have the opportunity to loan those funds from the company, where they may not be achieving a return. Providing it’s fully repaid within 9 months of the end of an accounting period ending, no tax charge would arise on the loan.
This can be helpful to those with shorter-term cash requirements or put to use by reducing the balance on an offset mortgage. Where a loan exceeds £10,000, interest, at HMRC’s beneficial loan rate of 3% or a tax charge, would arise on the interest avoided. The repayment of the loan within nine months needs to be a repayment that is not re-loaned for at least 30 days.
At ICS, we aim to help you withdraw funds from your limited company in the manger which works for you. Contact us and a friendly member of our team will be on hand to discuss your needs and requirements.