Avoiding or reversing inefficient profit extraction
Maximising tax allowances and rates
As a company owner manager you can to a degree manipulate your income for greatest tax efficiency. This is important because there are cut-off points where tax rates step up a level and tax allowances start to be withdrawn.
Tip. The latter part of March is a good time to review your tax position for the year as it gives you time to extract further income from your company at the lower tax rates or make payments that will bring your tax rates down. The following examples show how this can work in practice.
Example - using the basic rate band. Ali is the sole shareholder and director of Acom Ltd. In 2023/24 Acom has paid him a salary of £13,000 and dividends of £24,000. It also makes employer pension contributions of £10,000. He’s also made £3,000 profit from a side business and earned interest of £800 from savings. His total taxable income is therefore £40,800 (the pension contributions aren’t taxable income). £1,000 of the dividends and all the interest are chargeable at 0% because the dividend allowance and savings allowance apply respectively.
Tip. Acom can pay him a further £9,470 in dividends to bring his taxable income to £50,270, which is the basic rate threshold. He’ll pay tax at just 8.75% on the extra dividends (see The next step ).
Trap. If Ali takes more in dividends they’ll be taxable at 33.75% as they will fall into the higher rate bracket. What’s more, the savings allowance, which is £1,000 will be cut to just £500. This would mean that instead of zero tax on his interest earned Ali would pay tax on £300 (£8,000 - £500) of it.
Example - reversing higher tax rates. Assuming Ali’s income is the same as our previous example except that his dividends are £30,000 instead of £24,000. When he makes his year-end review Ali realises the extra £6,000 dividends has landed him in the above Trap.
Tip. If Ali makes a personal pension contribution of £6,000 it increases the basic rate threshold by an equal amount. This means the excess dividends are now taxable at 8.75% and his savings allowance is restored from £500 to £1,000.
Example - restore your personal allowance . Again, we assume Ali’s income is the same except that his dividend income is much greater so that his taxable income is £110,000. He is OK with paying higher rate tax but realises that because his income has exceeded £100,000 he loses £1 of his personal tax-free allowance for every £2 of excess income. Ali therefore loses £5,000 of his tax-free amount. This makes the effective rate of income tax on the excess £10,000 (£110,000 - £100,000) around 60%.
Tip. The same trick with personal pension payments (in this example £10,000) will restore Ali’s personal allowance and reduce the tax rates back to the normal higher rate for dividends.
Tip. Making a review before the end of the tax year can help you arrange your finances for tax efficiency by, say, bringing forward a pension contribution you intended to pay in the next tax year into the current one. This means you aren’t paying any more into your pension, but you are doing it more tax efficiently. A similar trick can be used for Gift Aid payments, as these have the same effect as pension contributions.
For the calculations behind each example with details of other tax cut-off points, visit https://www.tips-and-advice.co.uk , Download Zone, year 24 issue 12.
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