Extracting profits from a limited company efficiently – case study
2 March 2020
The Prudential Technical team provides a useful case study looking at how directors can efficiently extract profits from their company.
Robert owns a limited company and reviews his remuneration at the end of his reporting period, 31 March each year. He usually takes a combination of low salary and high dividends. The business has generated £100,000 of profit for the year and Robert uses the remuneration taken out in December to pay his bills etc for the next calendar year.
He does not see the value in pensions but knows that there will be no value left in his company when he retires. This is because he runs a personal services company, but does not have any issues with the IR35 rules. So all the value of the business sits with him. For this reason he has always extracted the full profits out of his company each year using a low salary / high dividend structure. He usually takes £10,000 in salary with the remainder paid out as dividends.
He is seeking advice to review his remuneration structure to see if this is still the best thing to do.
The Tax position
The simple answer to Robert’s position would be to alter his salary to £8,632, and the remainder as dividends to achieve maximum tax efficiency (£8,632 is limit where employees and employers become subject to paying National Insurance). This assumes that normal personal allowances, tax rates and national insurance apply. Detailed below is how this would look;
During a meeting with his adviser it transpires that Robert will only have fixed and discretionary spending of £3,958 a month for the next year. Based on this monthly figure this would leave an additional £21,870 in his bank account at the end of the year. The adviser challenges Robert as to why he is taking profits in such a way and he advises “this is what I have always done”. But is there a better way?
By altering the remuneration structure for this year to achieve the net c£47,500 that Robert requires for his expenditure. The company would have an additional £30,630 as retained profits from the net £21,870 that Robert gave up owing to smaller dividend payments being made (dividends were reduced by £32,400). This then gives scope to place £40,000 into a pension plan as an employer contribution, owing to the fact that corporation tax relief is available on employer pension contributions which means that £7,600 of corporation tax would be saved. This is of course subject to the wholely and exclusively rules.
This would alter the position above to the following
Basically there is more in his pension and HMRC receives a lot less from Robert and his business.
As Robert is above minimum pension age he could then extract money from his pension when he requires an extra income stream, possibly when he is looking to retire/sell the business. If 25% of the pension is taken as tax free cash and the remainder taxed at basic rate he will have turned the £21,870 from his present current account into £34,000 in his future current account. At higher rate this would be £28,000; additional rate would return £26,500.
Since the advent of pension freedoms clients have greater control over how much and when they take benefits from DC pensions. This means that with the right advice Robert can keep himself in a desired tax band. Assuming Robert is basic rate in retirement this would be an effective return from his present current account to his future current account of 55.46%. This doesn’t factor in any growth in the pension funds by the time he eventually draws on the money.
If Robert invested the £21,870 from his present current account (assuming that he moved to the efficient model detailed earlier), he would need significant outperformance over the pension investment to achieve this level of return.
Robert was taking far more from the business than he needed to. By simply taking what he needs to live on now and then funding a pension with the spare profits this creates, he is extracting the profit from his business in a more tax efficient manner.
This also has the added benefit of giving him an alternative income stream that he could use in the future should the business have a poor year.
Further to this, even if Robert were not willing to put the full £40,000 into a pension to use this year’s annual allowance, the importance of being a member of a pension before the end of the tax year is important for the availability of carry forward to be used.
The final bonus on this is that the money would be safe from creditors should the business fail (subject to the usual rules on contributions). We do have more in depth information on profit extraction should you need to refer to this.
If all of this was explained to Robert, would he now see the value in pensions?