Tax planning for owner managers before 5 April 2020
Annual exercise
The tax year-end review for individuals is likely to be one of your regular exercises. If it isn’t already a priority on your March calendar, make 2019/20 the first year that it is. The end of the tax year on 5 April 2020 is a watershed in terms of planning. Many tax reliefs are given by reference to the tax year. Some are lost if they are not used by the year end, so it is vital to try to utilise them as far as possible. Let’s have a look at the things you should be advising your owner-manager clients on.
Private companies
If you have clients who operate their trade through a limited company, the focus may be on profit extraction. The basic advice here hasn’t changed, i.e. to take a small salary up to either the secondary NI threshold (£8,632 for 2019/20) or, if the employment allowance is available, up to the level of the personal allowance (£12,500 for 2019/20). The remaining profit can be taken out as dividends if needed.
Pro advice. Remind clients of the double tax trap of taking dividends, i.e. that they will be subject to both corporation tax and income tax. More efficiency can be achieved if they restrict the dividends taken to a sufficient amount to fund their living needs. The money not withdrawn can then be the subject of some further planning without triggering an immediate income tax charge.
Example 1. Robert is the sole director and shareholder of Bruce Ltd. The gross profits for 2019/20 look set to be approximately £80,000. If Robert follows our basic strategy, he will take £8,632 as a salary, pay £13,560 in corporation tax on the net profit, then draw the remaining £57,808 as a dividend. His income tax bill will be £8,005, leaving him with £58,335 in-pocket after tax.
Example 2. Suppose that Robert doesn’t need that after-tax amount and so decides to restrict the dividends taken to the amount that will take him up to his basic rate band, i.e. £41,368. The corporation tax position will be unchanged, but the income tax will be just £2,663. There will be £16,440 of undrawn profit left in the company.
Pro advice. If your client does not need even this level of dividends, it may be worth declaring an amount to fully use the basic rate band anyway so that it is not wasted. The amount can be credited to the director’s loan account.
Undrawn dividends
What are the options for the undrawn profits?
Accumulate. The most basic option is to just leave them in the company until they are needed. Pulling out the undrawn profits closer to the time would certainly help with that, though they would be subject to tax at the dividend higher rate, i.e. 32.5%.
Retirement fund. Alternatively, the undrawn profits could be left in the company and used in retirement as an alternative, or supplementary to, a pension fund. This would allow the accumulated profits to be withdrawn and likely taxed wholly within the basic rate band.
Contribute. A third option would be to use the undrawn funds to make employer pension contributions. The upside of this is that the contributions will be deductible for corporation tax purposes. The obvious downside is that the funds will be locked away until the pension can be accessed.
Example. Robert decides to make a contribution of £15,000 to his pension via Bruce Ltd. He takes the same salary. Now the corporation tax reduces to £10,710. The amount available as dividends would be £45,658. If this is taken in full the income tax bill will be £4,057. This is an overall tax saving of £1,456 compared to withdrawing all the profit, and his pension fund has been increased.
This wouldn’t allow for extra funds to be taken in a later year, so Robert might want to restrict the dividends to £41,368 to use the basic rate band up. This would leave £4,290 in the company undrawn, i.e. it’s a halfway house.
Pro advice. This serves as a reminder that planning should always make your advice client led. Try to fit the planning around the situation, don’t force the client to fit their situation around the planning.
Post extraction planning
The profit extraction should not be the end of your review. Your client now has the cash extracted in hand and so may be looking for further advice on how to use it efficiently. What exactly this advice will be depends on the particular circumstances of the client, and their appetite for investment etc.
Tax-free returns
One of the first things to look at would be whether the client and their family members are using their ISA allowances. This is relatively low-level but ensuring all family members are utilised can be easily overlooked. Each adult can put up to £20,000 into an ISA, and any corresponding income will be tax free.
This can also be used to fund savings for children. The Junior ISA investment limit is £4,368 for 2019/20. For a typical family of four that’s almost £50,000 of investments that can be used to fuel tax-free income each year.
Pension savings
Additional pension savings are also a very tax-efficient way of using up surplus income. Check your client’s contribution history to determine the level of available annual allowance. The standard allowance is £40,000 per year, with the ability to carry forward any unutilised amount for three tax years.
Pro advice. Higher earners are subject to a controversial tapering of this allowance. It is crucial to understand if this applies to ensure correct advice is given. We discussed the tapering rules in detail in yr.3, iss.10, pg.8 (see Follow up ).
Risk capital investments
At the other end of the scale, one very powerful option would be to make an investment under the enterprise investment scheme (EIS). The purpose of doing so would be multi-faceted from a tax perspective.
Income tax. A qualifying investment attracts income tax relief at 30%, assuming the qualifying conditions have all been met. This might be particularly attractive in circumstances where your client wants to extract funds that have accumulated and are trapped in a company without incurring income tax at the higher or additional rates.
The extraction triggers the tax charge, but this is then mostly mitigated by the EIS relief claim. The funds will be tied up in the EIS company for at least three years, but this strategy gets it out of the trading company.
Pro advice. This might be an attractive strategy if there is a considerable cash balance in the company that isn’t required for the ongoing trade, particularly if the intention is to pass on the business to the next generation of family. Having a large cash balance in the company can affect the inheritance tax relief. It’s far better to have the cash in hand where it can be gifted or used to buy other assets qualifying for relief.
Capital gains. If the money extracted is needed immediately, e.g. for a one-off purchase, it might be possible to realise any investments standing at a gain to fund the EIS investment instead. The tax on the gain would be deferred, and your client would still be eligible for the income tax relief. This means that the cash is out of the company, but the immediate tax consequences are minimal. Refer to HMRC’s guidance on deferral relief for further information (see Follow up ).
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