People start businesses for a whole range of reasons, from passion to pride. However, financial security is probably at the top of most people’s lists.
Running a business is hard work. In most limited companies, the owners also double as directors, and sometimes business owners find themselves constantly investing in the company while failing to take a cut for themselves. That’s especially common during the start-up phase.
- Business profit extraction and the 3 main routes to take
- The contributions towards pensions and tax relief
- Director pay mixes between salary and dividends
What is Business Profit Extraction?
After you have worked every hour in the day and put 100% of your time and energy into your business, however, a time will come when you do want to extract money from your limited company for the first time to reward your own efforts.
This process, called ‘profit extraction’ in professional jargon, requires cautious planning to be as tax efficient as possible. Over the years, we’ve often seen people do what seems to be the obvious thing only for it to backfire when their tax bill lands.
What follows are just some of the strategies used to extract profits from businesses without paying an unfair amount of tax.
Business Profit Extraction Main Routes
When looking to extract profit from a business, there are three main routes which can be taken; salary and bonuses, dividends, and pension contributions. These methods allow business owners to see immediate returns on the profit that is made.
Your salary is an obvious way to extract profit from your business as you can move money into your pocket, dividends are often mixed in with salary because they are very tax efficient, as are pension contributions as the money is paid into an account straight from the business.
However, an alternative method of extraction is to allow profits to remain liquid within the business. This means that the profit can, eventually, be extracted through the sale of the business. Each method is subject to certain taxes so it is important to consider which method is appropriate to each situation.
Salary and bonuses
One of the most obvious ways to move money from a limited company to your own pocket is to pay yourself a salary.
However, it’s standard practice to take a relatively small salary when paying yourself as an employee of your own limited company, for a couple of reasons.
First, the cost is deductible as a loss when it comes to working out your business’s corporation tax bill.
Secondly, if you are entitled to the full personal allowance, you would not have to pay any income tax on a salary of £8,788 in 2020/21.
What’s more, your company won’t have to start paying employer’s national insurance contributions, and you won’t have to pay employee contributions, unless your salary goes above this level.
One thing to remember is if you have other sources of income – for example, savings interest or rental income – this also counts towards your personal allowance, along with the wages you’re paid through PAYE.
It’s also worth noting that in 2020, this approach caused problems for some people when it came to claiming government support at the height of the coronavirus crisis. The coronavirus job retention scheme (CJRS), also known as the furlough scheme, was the only support open to many self-employed company directors. As it was calculated as a percentage of salary, however, it wasn’t substantial for those paying themselves less than £9,000.
This highlights a flaw in the administration of the Government’s support schemes, though, rather than invalidating an approach that has worked well for most directors for many years.
Most company directors take their pay as a mix of salary, as above, and dividends.
After your salary and all other business expenses and liabilities have been deducted, the remaining profit from your company can be distributed to shareholders in this form.
Each individual is entitled to £2,000 as an annual dividend allowance, taxed at 0% – surely everyone’s favourite tax rate.
Additional dividends are subject to dividend tax in accordance with your income tax band.
|Tax band (England)
|Dividend tax rate
|Basic rate Up to £37,500 after allowances
|Higher rate Up to £37,501-£150,000
|Additional rate £150,000+
Dividends are one of the most tax-efficient ways to top-up your salary because they only get paid when your business is profitable, compared to a salary, which will continue to be paid during a period of loss.
Paying into a pension pot via the business is another tax-efficient way to extract profits from a company – and is increasingly popular.
This is because, first, when a business pays into an employee’s pension, those payments are once again deductible against corporation tax. The Government wants businesses to contribute to staff pensions, after all.
Secondly, company directors will get tax relief on pension contributions of up to 100% of earnings, or a £40,000 annual allowance – whichever is lower. If pension contributions exceed that allowance, they are subject to income tax, but at a much lower rate than salary.
The important point is that it’s always worth taking time to reflect on the options open to you beyond salary alone. In most cases, a balance of different ways of extracting profit will yield the best results, even if it means a bit more thought and a few calculations are needed upfront.
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Alistair Allcock is a Chartered Accountant at Rogers Spencer and has been working with us since 2012. Alistair specialises in Accountancy Solutions, Audits and Tax and Vat. Find out more about Alistair here.