Sarah Bradford considers what might constitute an optimal profit extraction strategy for 2023/24.
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As the 2023/24 tax year draws to a close, directors of personal and family companies should be reviewing the profits they have taken from their company so far in the tax year and considering whether it would be worthwhile to extract further profits before the end of the tax year on 5 April 2024.
Where a business is operated as a personal or family company, the profits need to be extracted if they are to be used by the director personally. There are various ways of doing this. This article looks at popular extraction strategies and the associated tax implications.
Salary: How much?
Taking a small salary can be very tax-efficient. Not only that, but if the individual does not already have the 35 qualifying years needed to provide full entitlement to the state pension, paying a salary at least equal to the lower earnings limit for National Insurance contributions (NICs) purposes (set at £6,396) will ensure that the tax year is a qualifying one. If the salary is at least equal to £6,396 and does not exceed the primary threshold of £12,570, this is achieved without the director having to actually pay any primary contributions.
The optimal salary will depend on the director’s personal circumstances and whether they have other income. If the director has no other income and the standard personal allowance is available, the optimal salary is one equal to the personal allowance of £12,570.
Where a salary is paid at this level, there will be no NICs for the director to pay either as for 2023/24, the primary threshold is aligned with the personal allowance at £12,570.
In a personal company situation where the director is the sole employee, there will be some employer’s NICs to pay as the company does not qualify for the National Insurance employment allowance. Employer’s NICs at 13.8% is payable on earnings in excess of the secondary threshold, set at £9,100 for 2023/24; on a salary of £12,570, this equates to £478.86 for 2023/24. However, as both salary and employer’s NICs are deductible when calculating the company’s profits for corporation tax purposes, it is worth taking the ‘hit’ as the associated corporation tax savings (at between 19% and 25% depending on the level of the company’s profits) will outweigh the cost of the employer’s NICs.
In a family company scenario where there are at least two employees and the company qualifies for the employment allowance, there will be no employer’s NICs to pay to the extent that the allowance shelters the liability that would otherwise arise.
Once a salary has been taken up to the level of the personal allowance, it is not worth paying a higher salary as the personal tax and employee’s NICs hit (plus the employer’s NICs hit where the employment allowance is not available) will outweigh any corporation tax savings.
Where the director’s available personal allowance is not £12,570, it is necessary to ‘do the sums’.
In a family company situation, a salary can also be paid to other family members to use up their available personal allowances.
Dividend strategies
Once the optimal salary has been taken, if the company has sufficient retained profits available, it generally makes sense to extract further profits needed outside the company as dividends. Paying dividends is less straightforward than paying a salary, as there are some rules that need to be adhered to.
For example, dividends can only be paid from retained (post-tax) profits, and where there is more than one shareholder for a particular class of share, they must be paid in proportion to shareholdings. Having an ‘alphabet’ share structure (i.e., whereby each shareholder has their own class of share) overcomes this restriction, allowing the flexibility to tailor dividends to the shareholder’s personal circumstances. Dividends must also be properly declared in accordance with company law requirements.
The profits from which dividends have been paid have already suffered tax of between 19% and 25% depending on the level of the company’s profits. If the company’s profits have remained static but the rate at which the company pays corporation tax has increased from 1 April 2023 onwards, the pool available from which to pay dividends may be smaller than in the past, and previous dividend strategies may need revisiting.
The rates at which dividends are taxed in the hands of the shareholder are lower than the standard income tax rates. Dividends are treated as the top slice of income and are taxed at 8.75% to the extent that they fall within the basic rate band, at 33.75% to the extent that they fall within the higher rate band, and at 39.35% to the extent that they fall within the additional rate band.
All taxpayers, regardless of the rate at which they pay tax, are entitled to a dividend allowance. This is set at £1,000 for 2023/24, but is reduced to £500 for 2024/25. The dividend allowance is not an allowance as such; rather, it is a nil-rate band. Dividends sheltered by the allowance are taxed at a zero rate but use part of the band in which they fall.
The availability of the dividend allowance offers scope to extract further profits from a family company without an additional personal tax liability by making family members shareholders regardless of whether they work in the company and paying them dividends to utilise their dividend allowances. However, the reduction in the dividend allowance means this is less effective as a profit extraction policy than in the past.
Once dividend and personal allowances have been used up, further dividends can be extracted to use up remaining basic rate bands, if more funds are needed for personal use.
Pension contributions
If profits are not needed for personal use immediately, making employer contributions to a pension scheme can be tax-efficient for both the director or family member and also for the company. Contributions are limited by (and count towards) the individual’s available annual allowance but are not subject to the earnings limit, which is useful where the director only receives a small salary (dividends do not count as earnings for pension purposes).
The employer contributions are generally deductible in calculating the taxable profit for corporation tax purposes, securing tax relief at between 19% and 25% depending on the level of the company’s profits. Reducing the company’s taxable profits may also reduce the rate at which the remaining profits are taxed.
Extracting profits in the form of pension contributions helps the director build up a retirement pot, 25% of which (up to £268,275) can be taken tax-free once the director has reached the age of 55 (57 from 6 April 2028).
Tax-free benefits
It is also advisable to make use of the various tax exemptions for benefits-in-kind, as this allows profits to be extracted in kind in a tax-free fashion. Of course, this is only valuable if the director actually wants the benefit, but the range of exemptions means that there should be something for everyone.
Popular tax-free benefits include mobile phones and trivial benefits of up to £50 (capped at £300 a year for directors of close companies and their associates).
Optimal strategy
There is no ‘one-size-fits-all’ and the optimal strategy will depend on the director’s personal circumstances and priorities, any other income they may have, and the funds needed for personal use.
A popular strategy is to pay a small salary (equal to the personal allowance where this is available) and, retained profits permitting, to extract further profits as dividends. This can be enhanced by providing tax-exempt benefits and making company contributions to the director’s personal pension.
Practical tip
Review profits extracted so far in 2023/24 and consider whether it would be beneficial to extract further profits before 6 April 2024 to make use of 2023/24 allowances and basic-rate bands.
