Profit extraction 2021/22

Absolute basics

Small company director shareholders often obsess with the best mix of salary and dividends every year when it comes to profit extraction . Of course, there is no single right answer to this - “best” is a subjective term, and ultimately what is best for your client will depend on what their financial needs are.

Let’s assume that by best, your client means that they want to extract all of the available profits from their company whilst paying the least amount of tax legitimately possible. The advice here then becomes relatively straightforward, as the tried and tested strategy is to take a small salary up to the secondary NI threshold (£8,840 for 2021/22) and then extract the remainder as a dividend.

Pro advice. If there is more than one employee such that the employment allowance is available, the small salary can be increased to £12,570 as the corporation tax (CT) deduction will save more tax than the primary Class 1 NI charged.

This strategy gets the money out of the company and into your client’s pocket in a way that is completely above board and is reasonably tax efficient. However, the year-end planning should be used as an opportunity for real added value, and this should merely be a starting point.

Coronavirus and working capital

The pandemic continues to affect businesses despite no outright lockdowns, particularly in hospitality. In January 2022, one pub owner in Cardiff lamented that a potential lack of fans allowed at Six Nations games would have cost him nearly £50,000 in revenue. The reality is that your clients may be more prepared to consider leaving additional working capital in the company.

If so, the strategy should switch to a more balanced activity, taking into consideration both the financial needs of the company and the shareholder. A basic example would be to continue to extract the profits, but leave them outstanding rather than physically paying cash. But this may not be optimal from a tax perspective.

Example. Kuldip is the sole director and shareholder of Acom Ltd. The profits for the year ended 31 March 2022 are expected to be approximately £120,000. This is broadly represented by cash in the bank and Kuldip’s overdrawn director’s loan account (DLA) which he has used to meet his personal expenses for the current financial period. Kuldip now wants to clear his DLA and, normally, he would do this by extracting all available profit, which after CT will be approximately £97,200. If he followed this policy again, by taking a salary equal to the NI secondary threshold (£8,840) and the remainder as dividends after taxes he would be left with a little under £80,000. The tax cost therefore being around £17,400.

Take it a step further

In the previous example, a better tax position could be achieved if Kuldip could restrict the dividends to an amount he actually needs to fund his day-to-day life. This would require some further estimations from him.

Example. Kuldip wants to leave more cash in the company and therefore decides to reduce the amount of profit he extracts to a level that more accurately reflects his needs. Let’s suppose he reduces the profits he extracts to around £50,000 after tax. This can be achieved by extracting approximately £53,000 using a mix of a secondary threshold salary (£8,840) and dividends of £45,490. This would leave around £44,000 profit in Acom almost entirely represented by cash in the bank (a large part of the profit taken by Kuldip having been used to repay the debit balance on his DLA). Acom’s cash position is now far healthier and it will be able to meet its foreseeable liabilities with ample left to cover any emergencies.

Pro advice. The reason for the large difference is that the marginal tax rate on Kuldip’s dividends is 32.5%.

Pro advice. As the emergency fund is only likely to be needed to be set aside once, the cash position in the company will increase rapidly if the extraction strategy is repeated in subsequent years.

Pro advice. You may find clients reluctant to leave funds undrawn as there may be a perception that it will be subject to tax anyway, so they might as well have it. You should remind them that leaving it in the company is actually more tax efficient, as dividends are not deductible for CT but still charged to income tax.

A word of warning

Without further planning, the tax “saving” using this strategy is really a deferral. If Kuldip takes the undrawn profits out as dividends in later years, they will be subject to income tax. Additionally, don’t forget that the dividend rates are increasing by 1.25% from April 2022.

Pro advice. For this reason, if your client is simply going to extract the profits once they feel the effects of the pandemic have subsided, they will actually be better off paying the dividends out before 6 April 2022, as long as doing so doesn’t push them into a higher tax band. They can credit them to the DLA if they want to retain cash reserves in the company.

However, if the profits can be left in the company in the long term the accumulated funds can become part of your client’s retirement planning. Dividends can continue to be paid when a company ceases trading, and so could be used to supplement pension income later in life.

Pro advice. Alternatively, the company could be wound up with the profits extracted as capital, subject to a number of conditions.

Further planning

So far, we have hit both of Kuldip’s targets, i.e. reserving sufficient cash in the company to cover short-term problems, and reducing the profit extraction to a level that means he can comfortably fund his day-to-day life. However, there is an opportunity for further added value work here.

As briefly mentioned above, the strategy we’ve looked at will mean additional cash in the company, which will continue to increase year on year if Kuldip continues to restrict his personal income. So, what could the company do with the additional cash?

One option might be for the company to make investments in its own right. Companies are generally exempt from paying CT on dividends, so investing the excess cash into listed shares, which can be sold relatively easily if funds are required, might be a good idea. Of course, any gains realised will be subject to CT. This option is very flexible.

A less flexible, but far more tax-efficient option would be to use the spare cash to make pension contributions. Employer contributions are deductible for CT purposes, so there are extra savings to be enjoyed.

Example. The facts are the same as the previous example, except now Acom makes a £15,000 pension contribution for Kuldip. Employer contributions are not restricted to earnings but are subject to the lifetime allowance. Kuldip’s personal tax position remains unchanged, but now Acom’s CT bill will reduce by 19% x £15,000 = £2,850.

The obvious downside is that the cash cannot then be used by the company, or withdrawn in future years by Kuldip if his living costs increase. The prudent thing to do is to ensure clients don’t adopt an “all or nothing” approach to profit extraction planning, and instead look at things with them on a needs-first basis. It’s an old cliché among advisors, but in these uncertain times it is more important than ever to make sure the tax tail isn’t wagging the family dog.