Once your new business is up and running, and revenues are finally coming in, you’ll quite rightly be considering how best to extract your well-earned cash! There are three main ways – salary, dividends, and director’s loan – which I’ll discuss below.
As director, you can pay yourself a salary just like you would for any employee – it will go through the business as an expense and therefore reduce your net profit (and by extension, what is subject to corporation tax). But a salary may incur other costs and tax liabilities, certainly over a certain threshold. Even if you choose to pay yourself the personal income tax free allowance, you will still owe around £880 per year in employee and employer national insurance contributions. Plus, by law, if you are a director with an employment contract, you may well have to deduct some of your pay and divert it into a pension scheme for yourself alongside contributions from your business too.
However, many business owners still find this method of paying themselves more convenient, certainly up to the point where National Insurance is due (though they should take advice on the impact to their state pension if not paying this tax for an extended period). A salary provides a regular, predictable income, and most payroll software packages will automatically calculate taxes and pension costs – our practice recommends Xero which performs this task well, and automates the filings with the two main pension schemes used by small businesses.
It also has the benefit of reducing the profit subject to Corporation Tax in most cases, although beware the so-called “Wife’s Wages” trap. Paying your partner when they don’t do any work can mean that corporation tax benefit is forfeit.
Directors may also pay the company’s profits to its shareholders in the form of dividends. To do this, you must hold a meeting and keep minutes (even if you are the only director) and write up a dividend voucher for your records. Dividend income is subject to the personal tax regime; allowances may exist but are contingent on your individual circumstances.
Unlike salary payments, dividend payments do not affect your business’s profit. A dividend is a distribution of your company’s bottom line profit, not an expense, which means you must not pay out more in dividends than the company’s available reserves (including previous years). It’s important to remember that cash in the bank is not the same as available reserves!
This may seem obvious, but many directors have made this mistake and withdrawn cash assuming that, if the cash is there, the profits must have been made. But if the amount withdrawn is greater than the available profits, it cannot be a dividend – it must be treated as a director’s loan. What makes this worse is that the first set of accounts and corporation tax return isn’t due until around 1 year and 9 months after the company was formed, meaning a few of our clients have come to us having been stung by this.
Sometimes a director will withdraw cash from the business, but not as a dividend nor salary – this is fine, but it must be accounted for correctly on the company’s balance sheet. In practice, directors often make frequent payments into their company by paying for office supplies, travel expenses and other business necessities and may well take an advance to pay for flights or other forthcoming, legitimate, expenditure. But if you withdraw over £5,000 more than you put in, then the company needs to pay corporation tax – at an eye watering rate of 32.5%. Unfortunately, it was once a well known tax avoidance scheme to have royalties or earnings paid into a company and then a loan advanced to an individual that was never repaid, so now many well-meaning and hard-working small business owners get caught out.
Furthermore, if you owe the company over £10,000 you will also likely need to pay personal taxes, as a loan over this size is treated as a benefit in kind in relation to it being interest free. Writing the loan off will trigger other tax liabilities on the full amount written off.
Oh, and if it is eventually repaid more than 9 months after the end of the financial year in which it was advanced, getting the corporation tax repaid by HMRC is an arduous process.
As a director it is crucial to keep careful track of everything you pay into the business and everything taken out – this is best done by using specific accounts on the balance sheet, through which all transactions are recorded. By doing this you can look at the company’s balance sheet at any time and see exactly how much you owe the company.
More importantly, it’s crucial to monitor the accounting profit; the reserves that can be distributed as a dividend, which are also shown on the balance sheet. The figure is often the net result of a bunch of “voodoo” your accountant has to do to the books and isn’t always as clear cut as what your accounting system may spit out without intervention. For example, if your business has revalued assets, that may looks like reserves; problem is, the second that element of the reserves is distributed, other tax liabilities may kick in.
This is why many of our clients take packages from us that include doing that “voodoo” monthly or quarterly so there are no surprises long after the year has ended.
Generally it’s inadvisable to borrow large amounts from your business, partly for the tax reasons above and partly because, if you’re looking for investors for your business later, a large loan to a director on the balance sheet can be an obstacle. Then consideration is needed as to its status if the business were to fail; the director with the loan is a creditor and may find themselves pursued for repayment.
COMBINATION – SALARY AND DIVIDENDS
This is often the best choice but will be a function of personal tax planning.
If you are a new business owner and need further information or advice on any of the methods described here, there is more detail available on the UK government website including specific tax rates for different levels of income. Alternatively, feel free to contact me at [email protected] for a quick chat about what options may best suit you and whether our fixed price tariffs may help you avoid these pitfalls!