How to balance increasing limited company taxes and profit extraction

In recent years, the government has been slowly eroding the potential tax advantages of operating a small business through a limited company compared with being in ‘traditional’ paid employment or operating as a sole trader. Typical methods of operation of small companies involve the director shareholders taking small salaries, topped up by tax advantaged dividends.

The benefits of operating in this way have however been eroded as a result of the reforms to the dividend tax rates. The formerly available 10% dividend tax credit was removed in April 2016 and dividends became taxable at the rate of 7.5% for basic rate taxpayers. Although a £5,000 dividend allowance also came into operation, this increased tax rate – rising to 32.5% for 40% taxpayers, and 38.1% for 45% taxpayers – means the tax savings achievable have been reduced, in some cases quite significantly.

These changes give rise to two important questions. Firstly, is it in fact tax advantageous to trade through a limited company and secondly, what is the most tax efficient way for a company director/ shareholder to remunerate themselves? Advising on the best ways to tax efficiently extract profits from a limited company has become one of the questions that we, as tax advisers, are most commonly asked by our clients. 

Is it still tax efficient to operate as a limited company?

The short answer is yes. Although the tax differential between limited company and sole trader status is narrowing, there are still many advantages to operating within a company structure, not least of which is flexibility. However, the tax advantages vary quite considerably and in some cases, the benefits will be negligible considering the additional administrative and accounting overheads of incorporation.

The following table compares different post tax income levels for the 2017/2018 tax year to illustrate this point and highlights at what point a limited company is the best option.

What other factors should be considered?

Apart from post-tax income there are other significant factors to take into consideration, for example:

• The positive perception that being a limited company vs sole trader can create in the eyes of commercial stakeholders;
• The limited liability provided by company status vs being a sole trader, although this can also be achieved by operating through an LLP;
• The availability of corporate tax reliefs including R&D tax credits and EIS, that are not otherwise available to unincorporated businesses;
• Flexibility on how and when to remunerate directors and shareholders;
• Lower tax rates on profits retained and much lower corporation tax rates from 2020.

For businesses involved with innovation, the availability of R&D tax credits for limited companies can be extremely helpful in funding development. A far wider range of companies are now successfully accessing this tax relief than have done so in the past and the regulations have recently been relaxed to also include backdated claims for reimbursed employee expenses.

Other methods of profit extraction from limited companies

In addition to taking dividends, there are also other methods of tax efficient profit extraction from companies, such as:

• Company pension contributions – the most efficient method of fund extraction currently. The shareholder is also able to access flexible draw down and may benefit from lower effective tax rates during retirement. The company may also benefit from additional R&D tax relief at the enhanced rates;
• Loan interest – if a director has surplus personal savings it may be possible to loan an amount to the company and receive interest payments from the company;
• Rental payments on privately owned commercial property – although this is an efficient method of fund extraction, it can have implications for entrepreneurs’ relief and this needs to be planned for well in advance of a disposal.

Through careful tax planning it can be possible for a single company director to draw up to £22,500 in tax free income during the 2017/18 tax year, using a range of tax reliefs and allowances available. For example, by taking a small salary to the value of the NIC threshold, which is currently £8,164 p.a., interest to utilise the remaining personal allowance, the £5,000 savings and basic rate allowance, plus £5,000 in dividends to utilise the dividends allowance too. Where appropriate and legitimate to do so, it may also be possible to involve spouses and adult children in a limited company, and in doing so, utilise their own tax allowances too.

In summary, the introduction of the new dividend allowance and increased dividend tax rates has meant that the vast majority of limited company owner directors are now facing slightly higher tax bills. However, there are also many more corporate tax reliefs available to potentially benefit from. In most cases, incorporation, or remaining incorporated, is still worth the slightly higher tax bill and by working in partnership with your tax adviser it’s possible to identify acceptable ways to limit total tax liabilities.

If you would like to review your financial affairs and discuss tax planning opportunities with us in detail please contact Lesley Stalker by emailing partners@rjp.co.uk.