When it comes to extracting funds from a family company, all routes are not equal and there are various options available. Careful tax planning is essential to ensure that the most tax-efficient strategy is adopted and professional advice should be sought in advance.
In the main, the income extraction debate centres on whether to attract profits in the form of a salary/bonus or in the form of a dividend. Dividends come with an associated tax credit of 10% and in the hands of the shareholder do not suffer a further tax charge until the basic rate band has been used up. Thereafter, a higher rate taxpayer pays tax at 32.5% on the grossed-up dividend. For an additional rate taxpayer, the rate is 37.5%. A further advantage associated with paying a dividend is that no National Insurance contributions (NICs) are payable by the employee or the employer.
However, dividends must be paid out of retained profits, so the company does not benefit from a corporation tax deduction, and must have sufficient retained profits to pay the dividend. The dividend must also be paid in accordance with the shareholdings.
By contrast, profits paid out by way of a salary or bonus are taxable at normal income tax rates once the personal allowance has been utilised (i.e. 20%, 40% or 45%) and are also liable to Class 1 NIC (i.e. employee and employer). However, the company benefits from a corporation tax deduction for both the salary or bonus payments and the employer’s NIC.
A popular strategy is to pay a small salary (of between the Class 1 NIC lower earnings limit (£109 per week) and secondary threshold (£148 per week), and thereafter dividends until the remainder of the personal allowance and basic rate limit has been utilised).
It may also be worthwhile to consider alternatives, such as pension contributions or tax-free expenses and benefit, or (to the extent that this is possible) capital.
The benefits of extracting capital rather than income stem from the fact the rates of capital gains tax (CGT) (at 18% and 28%) are much lower than the rate of income tax (at 20%, 40% and 45%). A further advantage is that the availability of the CGT annual exemption, currently set at £10,900, makes it possible to extract capital up to this limit without triggering a CGT bill.
However, despite the obvious attractions associated with extracting capital, options for capital extraction are severely limited if the company is on-going. While selling shares back to the company is a possibility, there are pitfalls and advance clearance that the capital treatment will be forthcoming should be sought from HMRC.
Practical Tip :
Professional advice should be sought to help achieve an optimal extraction policy. Whilst capital extraction can be attractive in theory (particularly once dividends have been extracted to the basic rate limit), in practice options for capital extraction while the company is ongoing are severely limited.
However, if the company is to close, the options for taking capital are wider. A further benefit is the availability of entrepreneurs’ relief (which reduces the rate of CGT to an attractive 10% on gains up to £10 million) provided that the associated conditions are met.
Where a company is to be closed down it is also possible to extract accumulated profits as capital rather than as a dividend. However, it is now only possible to take this route if retained profits are not more than £25,000 without formally liquidating the company, as the capital distribution treatment is capped at £25,000 on the dissolution of the company in the absence of a formal winding up.