Mr Sinclair (age 57) owns and operates a software development business. The business generated £300,000 of surplus capital that is not required to run the business day-to-day. Not happy with the investment return currently available, Mr Sinclair has decided to seek advice to help maximise his return on the surplus capital.
At a meeting with his accountant it is established that, other than the £300,000, Mr Sinclair’s business has few other assets. This means that as more than 20 per cent of his business assets are deemed as “non-trading” he is in danger of losing his entitlement to entrepreneurs’ relief.
The recommendation from his accountant is that he extracts a substantial portion of the surplus capital from his business.
When an owner extracts money from a business this sum is subject to corporation tax, income tax and national insurance.
Many small business owners decide to take a salary of around £7,000 and any remaining profit as dividends. This is to keep the salary between the lower earnings limit and the primary threshold for NI, ensuring entitlement to state benefits is maintained at no NI cost.
As the rate of income tax on dividends is lower than the rate applied to a salary, and basic rate tax credit also applies, an individual can receive up to £41,865 before any further tax is payable. However, if you go above this amount higher rate tax will be due on the entire dividend.
So, of the two methods of providing “cash in the bank” today, it is very clear why taking a dividend rather than a salary is often the preferred option of business owners (see table).
However, if the money being extracted from the business is not required immediately this can have a bearing on the method chosen to acquire the funds.
As pension contributions are free of all taxes and NI, and do not have to pass through any of the HMRC “tax walls” that apply to salary and dividends, making pension contributions to extract money from a business for future use can often make good sense.
Of course owners must remember to leave enough money in the bank to cover day-to-day business expenses, as pension savings can normally only be accessed after age 55.
However, there are two restrictions Mr Sinclair should be aware of when thinking about making pension contributions: the maximum contribution for tax relief and the annual allowance.
As Mr Sinclair is the business owner he can make an employer contribution to his own pension and this is not restricted to relevant earnings.
Instead Mr Sinclair must make sure his contribution is “wholly and exclusively for the purposes of trade”. While it is generally acceptable for a business owner to remunerate themselves via a pension, it is always worth checking this with an accountant.
The second restriction relates to the annual allowance, which broadly restricts tax relief on pension contributions above £40,000. Historically, this was ignored in the year of retirement so a business owner could fund their pension with the proceeds of selling the business.
This is no longer the case. To help in these situations, carry forward was introduced. This allows unused annual allowance to be carried forward from the previous three years to the current year. To qualify for carry forward, Mr Sinclair must have been a member of a pension scheme in those years. This could allow Mr Sinclair to make a total contribution of £190,000 [3 x £50,000 + £40,000].
As this figure is less than the £300,000 capital available, Mr Sinclair can also look to use the following year’s annual allowance in the current tax year. This will allow a further £40,000 of pension contributions, bringing the total to £230,000. Additionally, this could be repeated in the new tax year to utilise the 2016/17 annual allowance, which would mean a total of £270,000 invested in pension contributions by the end of April.
This would leave 10 per cent (£30,000) of the original capital, which can then either be invested within the company or extracted.
As Mr Sinclair is over the age of 55, under the new pension rules, the full £270,000 of pension contributions could be exacted to provide £192,732 of net income, based on the 2015/16 rates. Naturally, tax rules and rates could be different in the future when Mr Sinclair takes his pension.
On this basis, should Mr Sinclair wish to use the proceeds of his profitable year to put money aside for his future, a pension could prove a very tax efficient way of doing this.
Darren McAinsh is technical manager at Prudential