Last week I looked at Government action in relation to the consequences of generating earnings/profits via employment, self-employment (including partnerships and LLPs) and private limited companies.
Now I want to focus on the tax changes that will need to be taken into account in determining the optimum strategy for available funds generated through profitable endeavour.
Of course, considering the options for available funds and their tax consequences is only really relevant in relation to owner/managers of private limited companies.
Profits generated from self-employment are treated in their entirety as available to the generators, and bear tax accordingly. So whether a sole trader spends the money their trade generates, transfers available funds from a business account to a personal account or leaves it in the business account, the tax result is the same. It is all taxable as the sole trader’s income.
The same is true for partners and members of an LLP: they will be taxed on their share of profit regardless of whether it is drawn or not. To the extent that funds are left in the partnership account, they will constitute an addition to partnership capital or represent the creation of, or addition to, a loan account. In both cases, the partnership will effectively be indebted to the partner to the extent of their left funds.
Companies are separate legal entities. Where this is the trading basis, there is a choice to make in relation to funds generated by the company.
But before we consider taxation, you have to think about the commercial determinants. Are the funds needed for corporate investment, to repay corporate debt or represent/enhance working capital? The answers to these questions need to be factored into the decision making. Only where funds are not required for business purposes is it worth considering how best to extract funds.
If you do get to this point, you have to consider why the extraction from the company is being made. Is the “personal need” for immediate expenditure or investment?
If the former, the choice is between dividend or salary (aside from any repayment of an outstanding director’s loan, which should always be considered first as a means of extracting money from the company without tax penalty).
If the latter (and to the extent you are not constrained by the annual or lifetime allowance) then a company pension contribution could be worth considering.
So what is new in tax terms that needs to be factored into funds extraction decision making? Well, the arrival of 2017/18 marks:
- A cut in the main rate of corporation tax from 20 per cent to 19 per cent.
- A £2,000 rise in the higher rate threshold to £45,000 (in Scotland the threshold remains at £43,000, but for earnings not dividends).
- A corresponding increase to £45,000 in the upper earnings limit for National Insurance contributions for all UK residents. The starting point for NICs increases marginally for employers and employees to £8,164 per annum (£157 a week).
These changes have an impact on the salary versus dividend versus pension contribution decision. With this in mind, I want to use the next couple of articles to take a look at some of the basic considerations in making the selection.
At this point, it is important to remember that further changes are due in 2018/19:
- A reduction in the dividend allowance to £2,000 (already in the Finance (No 2) Bill). This will increase the tax payable on dividends by a maximum (for those with dividends exceeding £5,000) of £225 for a basic rate taxpayer, £975 for a higher rate taxpayer and £1,143 for an additional rate taxpayer. The move is subject to the House of Commons debate being held today, and may come out of the Bill altogether.
- Likely further increases to the higher rate tax threshold (and hence upper earnings limit), en-route to the Government’s goal of £50,000 by the end of this Parliament (2020/21).
With this limited lifespan in mind, for 2017/18, a salary of £8,164 will generally make sense before any other payment is considered. The figure is chosen to match the primary (and secondary) earnings threshold and means there is no employee or employer NIC involved, but the employee gains a NIC record.
At this level, the salary will also fall fully within the individual’s personal allowance, assuming there is not more than £3,336 of other earned/pension income and that the personal allowance is not subject to £100,000+ tapering. Salary is an allowable expense so provides a corporation tax saving. More on this fascinating subject to follow.
Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn