Chris Thorpe gives an overview of whether it is best for a company to distribute or accumulate its profits.
With a sole trade or a partnership, whether to accumulate or withdraw profits is an irrelevant question – the profits are already the owner-partner’s; they are subject to income tax on those profits whatever happens to them.
By contrast, a limited company is a separate entity – the profits are the company’s and it is a matter of choice whether the taxed profits stay in the company or are distributed to the company’s owners – but the tax implications vary.
Keep it in the company
By keeping profits within the company and not declaring any dividends or paying any salaries, there are no further tax implications – corporation tax is paid on the company’s profits in a year and that’s it.
The potential issues that can arise relate to capital taxes – inheritance tax (IHT) and capital gains tax (CGT) – if the company’s shares are gifted, sold or bequeathed later on.
Excess cash
If a trading company has accumulated cash on the balance sheet which is not ‘working capital’, thus playing no part in the business, there is a potential danger of HMRC’s ceasing to regard the company as trading for CGT purposes – this would restrict gift holdover relief and deny business asset disposal relief (BADR) and rollover relief.
If a company is being used as a retirement moneybox with profits just rolled up until cessation of trading, BADR may not be available on liquidation. A company subject to these reliefs needs to be ‘substantially’ trading or professional (which HMRC defines as 80%+ with respect to the company’s activities).
As far as IHT is concerned, the availability of business property relief (BPR) could be restricted for the same reason – that ‘excess cash’ could be deemed as an ‘excepted asset’ and discounted from the relief.
Distributing the profits
Depending on how these profits are distributed, this may have no further implication on the company’s taxation – usually, most of the profits are taken as dividends which are paid post-tax, so they will only attract income tax for the individual shareholder.
However, salaries and pensions are tax deductible for the company (as is interest and rent, which could be paid to the shareholder if their capital or real property is being utilised), so these should be factored into the overall tax burden as well as the director shareholders’ personal tax positions; usually, most of the profits are extracted through a mixture of mainly dividends and some salary or pension.
However, if all or a majority of the profits are being extracted, the imposition of double taxation (i.e., profits subject to corporation tax and the same taxed again under income tax) may call for a limit on the amount of profits withdrawn. One trait of the limited company is that the extent of withdrawals and resulting personal tax liabilities can be controlled. If all profits are being withdrawn, it may be that trading as a sole trader, partnership or LLP is more beneficial from a tax perspective as all the profits are taxed solely under income tax – as opposed to both income and corporation taxes.
Practical tip
As usual with questions about what to do for the best, the circumstances need to be considered ‘in the round’ – the director shareholders’ personal situation and demands, their marginal income tax rates, their intentions for the business and succession planning, etc.
Keeping all the profits in the company and away from shareholders or directors will keep income tax to a minimum, but those individuals will want to benefit at some point, so having cash just sitting in a company may be of little use. However, too much profit withdrawal might make the double taxation rather expensive. Proper planning is required to ascertain whether to withdraw profits and if so, what the dividend or salary portions should be.
