Business owners are having to rethink how they extract profits from their company and pensions are most definitely in their thoughts. Changes in April to how dividends are now taxed could see a reduction in the spendable income they currently receive. A pension contribution could be the best way of cutting their tax bill, while still receiving the same level of benefit. And the best time to start extracting surplus profits could be right now.
Paying themselves dividends is still a better option than the equivalent amount of salary. But the gap is narrowing for high earning directors. A director receiving a net dividend of £100,000 will be £6,300 worse off under the new rules.
Since April everyone is now getting a £5,000 tax free dividend allowance. Dividends in excess of the allowance will be taxable at 7.5%, 32.5% or 38.1%. Currently business owners only pay tax on dividends when they take income above the basic rate tax band. That’s because the notional 10% tax credit, which was abolished from April, satisfies the liability for basic rate tax payers. So from April business owners could be paying a higher rate of tax on a larger slice of their income.
Tax efficient extraction
But a pension contribution remains the most tax efficient way of extracting profits from a business. An employer pension contribution means there’s no employer or employee NI liability – just like dividends. But it’s usually an allowable deduction for corporation tax – like salary. And of course, under the new pension freedoms, those directors who are over 55 will be able to access it as easily as salary or dividend. With 25% of the pension fund available tax free, it can be very tax efficient – especially if the income from the balance can be taken within the basic rate.
The table below compares the net benefit ultimately derived from £40,000 of gross profits to a higher rate taxpaying shareholding director after April.
|Pension income taxed @ 20% 1||Pension income taxed @ 40% 1|
|Corporation tax @ 20%||£0||£8,000||£0||£0|
|Employer NI 2||£4,850||£0||£0||£0|
|Director’s NI 2||(£703)||£0||£0||£0|
|Income Tax||(£14,060)||(£8,775) 3||(£6,000)||(£12,000)|
|Net benefit to director||£20,387||£23,225 3||£34,000||£28,000|
1 Assumes pension benefits are taken within the Lifetime Allowance.
2 Assumes NI rates for 2015/16 (13.8% employer, 2% employee).
3 Assumes full £5,000 annual dividend allowance is available.
The financial dangers of hoarding cash
There may also be a spin off benefit of paying surplus profits to a pension instead of capitalising it.
Shares in unquoted trading companies normally attract IHT business property relief (BPR). But cash built up in the company bank account or investments held within the company could be regarded as an ‘excepted asset’ and not qualify for BPR.
Paying into their pension could help ease this. There is typically no IHT payable on pension death benefits. Extracting the cash from the business in the form of a pension contribution could result in an immediate reduction in the business owner’s estate. And once inside a modern, flexible DC pension the wealth can be cascaded down the generations outside their estates.
Capital Gains Tax
Holding excess cash in the business could cause similar issues when shares in the company are sold. Entrepreneurs’ relief is valuable to business owners as it can reduce the rate of CGT payable on the disposal of qualifying shareholdings to just 10%. To qualify the shares must be in a trading a company.
While cash reserves are not looked at in isolation, holding substantial cash and other investments could contribute to a company losing its ‘trading’ status. And unlike BPR, entrepreneurs relief is all or nothing. If cash and investments trigger a loss in relief it affects the full value of the business disposed of; not just the non-trading assets.
This could have huge implications for business owners approaching retirement and planning to sell their business as part of their exit strategy. Extracting surplus cash through pension planning to ensure entrepreneurs’ relief is secured on sale of the business will be an important consideration. And there’s no CGT on pension assets.