The questions surrounding the issue of how best to extract profits from a company in a tax-efficient manner remain as popular as ever. Despite the introduction of the dividend allowance, and the personal savings allowance, extraction by remuneration and by way of dividend remain the two most widely used methods. The tax effects of these methods may be broadly contrasted as follows:
- Provided the amount is justifiable, remuneration is generally allowed as a deduction in arriving at the taxable profits of the company. The recipient is taxed on the remuneration through the PAYE system at the date of payment including a charge to NIC.
- Dividends are not deducted in arriving at the taxable profits.
The main point to note is that the question of how best to extract profits from a company is rarely straight-forward and will be different in nearly every case. Seeking advance professional advice is always highly recommended.
It must be remembered here that payment of a salary will give rise to a liability to National Insurance Contributions (NICs), whereas payment of a dividend does not.
In considering the options, a number of other factors should also be taken into account:
- A full NIC contribution record must be maintained to ensure maximum social security benefits. Therefore, a reduction in salary may have the knock-on effect for reducing future entitlement to certain earnings-related social security benefits.
- The lack of a salary charge in the accounts may increase the value for capital gains tax (CGT) and inheritance tax (IHT) purposes of holdings valued on the basis of earnings. In addition, a higher dividend payment will increase the value of a holding calculated on a dividend yield basis, although it is unlikely to affect the valuation of a major interest.
- Dividends are payable rateably to shareholders in proportion to their holdings in the company, which may not necessarily correspond to the relative efforts of the directors in earning the profits. Dividend waivers may assist in these circumstances, but care must be taken – always seek advice on such matters.
- Dividends can only be paid out of distributable profits whereas, in theory, salaries may be paid out without reference to the level of profits.
- The national minimum wage legislation should be considered, as this applies equally to directors under contracts of employment as it does to employees.
Given that dividends are treated as distributions of profits (after taking into account payments of salaries and wages), payment of a reasonable salary may be considered before thinking about a potential dividend payment. The situation will vary from company to company and there is no set rule. Seeking professional advice is recommended before any action is taken.
In deciding how profits are to be extracted, the following aspects should be considered:
- The rates applicable to dividend income are currently the 7.5% ordinary rate, which applies up to the basic rate limit, the 32.5% dividend upper rate, and the dividend additional rate of 38.1% on dividends above the higher rate limit.
- From 6 April 2016, 10% tax credit attaching to dividends was abolished and the new dividend allowance took effect. This means that the first £5,000 of dividends will be tax-free in the hands of the recipient. Whilst these changes mean that most taxpayers will thereby pay less tax, people with a share portfolio valued at £140,000 or more (according to the Treasury) will pay more. This forms part of the government strategy to reduce the incentive to incorporate businesses and take remuneration in the form of dividends.
- Individual needs of shareholders may differ – some may require income, others may be more interested in capital appreciation. These conflicting interests may be met by the issue of separate classes of shares with differing distribution rights.
- For the financial year 2017, the main rate of corporation tax is 19%, which means that the rate of tax payable on retained profits is potentially lower than current income tax rates.
For income tax purposes, and within family-owned companies, it is generally desirable to spread income around the family to fully utilise annual personal allowances and to take full advantage of nil and lower rate tax thresholds, wherever possible. The term ‘family’ includes all individuals who depend on a particular individual (e.g. the owner of the family company) for their financial well-being. This may include not only the spouse, civil partner and children but also aged relatives, retired domestic employees, etc. Care must be taken in this area not to fall foul of the ‘settlements’ legislation and other anti-avoidance measures in force at the time. Once again, professional advice is always recommended in advance of making any payments.
Distributions (usually dividends) from jointly owned shares in close companies are not automatically split 50/50 between husband and wife, but are taxed according to the actual proportions of ownership and entitlement to the income.
Possible methods of spreading income around the family include employing a spouse and/or children, waiving salary (to increase profits available as dividends) or dividends (to increase the amounts available to other shareholders), and transferring income-producing assets.
Some distributions of income to family members will not be beneficial for tax purposes. The following points require careful consideration:
- salaries and wages paid to spouse, civil partner, children or other dependants will be a tax deductible expense of the company only if they can be justified in relation to the duties performed;
- a salary paid to spouse, civil partner, children or other dependants will attract a liability to NIC if it is above the lower earnings limit; and
- the investment income of an infant child (i.e. an unmarried child below the age of 18) is taxed on his parents, where it arises from a gift by them.
In the longer term, there is a risk that, at some future date, the relative advantages of each extraction method might be reversed at a time when the flexibility to switch between the two methods is restricted. Currently though, using a mixture of salary, benefits and dividends, which can be varied according to individual circumstances, remains the most sensible option.