Remuneration planning for owners and entrepreneurs
Nobody likes the idea of working hard only to let those precious profits leak away in tax. Here’s how to maximise the income from your business.
It’s easy at first, isn’t it? As a sole trader getting something off the ground, you are the business. Or, to put that another way, the business’s income is your income.
You don’t need to complete a corporation tax return – it’s all covered by your personal income tax.
A time will probably come, though, when you want to formalise things and set up a limited company.
For one thing, until you do so, that ‘you are the business’ thing may keep things simple but is also a risk. If the business fails, you could lose your home and other assets. As the director of a limited company, on the other hand, you are less exposed: you and the business are separate entities.
With our own specialist expertise in mind, you also have to be a limited company to qualify for research and development (R&D) tax relief – a major benefit for innovative and tech-led businesses.
And though running a limited company brings more paper work and statutory obligations, it also gives you more options for paying yourself in tax efficient ways.
Salary vs. dividends
As the director of a limited company, you are an employee and could take the straightforward route of paying yourself entirely through salary. So why wouldn’t you do that?
Well, because the tax you pay on salary, especially if you’re earning a decent amount, is higher than you pay on some other forms of remuneration such as share dividends.
Most owner-operators pay themselves a basic minimum salary (at least £6,240 per year in 2020/21 and 2021/22) and make up the balance of their income with dividend payments.
The small salary means they maintain their entitlement to a state pension without having to pay National Insurance. What’s more, it’s also an allowable business expense, reducing their business’s overall corporation tax bill.
The dividend payments won’t incur a National Insurance liability and there’s no tax on the first £2,000 in dividends for 2020/21 and 2021/22. Tax is then paid at the following rates:
You have to account for the dividends you receive on your personal tax return and pay any tax due.
Be aware, though, that to pay dividends, your company must have made a profit after paying business expenses, VAT, corporation tax and any other taxes.
No longer a no-brainer
For years, this salary-dividend split was an obvious choice but that’s not necessarily the case today.
For starters, the Government has lowered the tax-free allowance on dividends – can you believe it was £10,000 as recently as 2015?
Last year was also a shock to the system for many company directors. The furlough scheme (CJRS) was payable at 80% of salary, but not on income from dividends. That meant they weren’t entitled to much at all if they’d followed the standard salary-dividend split.
Of course we don’t expect a national emergency to hit every year but it’s a sign of the Government’s attitude and direction of travel.
It’s certainly always worth doing full and detailed calculations before deciding on your approach to getting paid – and you should keep that under annual review.
Not, as it happens, that dividends are your only option these days.
One behaviour the Government does want to encourage is saving for old age. With that in mind, it’s become increasingly common for company directors to take a portion of their income in the form of pension payments.
It’s not ideal if you’ve got your mind set on buying a Maserati in May, but it does make sense to start thinking about your future as early as possible in your career.
In terms of tax, payments direct from the company to directors’ pension pots come with a few advantages. First, like dividends, they incur no National Insurance liability. And, also like dividends, they count as a business expense, deductible from company profits before corporation tax.
You do need to make sure they meet HMRC’s rules for allowable deductions, though, being ‘wholly and exclusively’ for business purposes. In particular, HMRC might probe whether contributions are excessive for the value of the work you do, or if it’s noticeably higher than the pension contributions employees receive from the company.
Savings in the form of ISAs
Another option is to pay into an ISA which is one of the best tax-free benefits around these days – and easy to use, too.
In each tax year you get an ISA allowance which establishes the maximum you can pay in. For 2020/21 and 2021/22, this is £20,000, which you can split between:
● cash ISAs
● stocks and shares ISAs
● innovative finance ISAs
● lifetime ISAs
A few years ago, before interest rates crashed worldwide, ISAs also had good earning potential. Even now, they often have slightly higher rates of interest than standard savings accounts.
At any rate, any savings or investments you keep in ISAs will continue to earn interest and tax benefits until you withdraw it.
Seed enterprise investment scheme (SEIS)
Finally, here’s a complex but interesting option: as a director, you can invest in your own company and then claim tax relief of up to 50% on that investment through SEIS. Not only this but provided you've held the shares for 3 years any gains made on selling the shares is free from Capital Gains Tax or Inheritance Tax.
Lots of terms and conditions apply, however.
The company must be eligible to begin with, with fewer than 25 employees and trading for less than two years, among other criteria. And the investor-director in this scenario can’t own more than a 30% share in the company.
So, this won’t be universally applicable, but it’s certainly worth exploring.