Tax Efficient Ways To Pay Yourself As A Business Owner
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What is the most tax efficient way to pay yourself as a business owner in the UK? We look at how much to pay yourself and typical business owner salary.
How to pay yourself as a sole trader or as a company
Depending on how your business is structured, you will have to pay yourself and your taxes in a specific way. For example, if you've done nothing to turn your business into a limited company, you will automatically have to pay yourself as a sole trader or self-employed person.
Sole traders and partners in a partnership pay themselves in the same way: by taking money out of their business. These withdrawals are considered taxable profits by HMRC so that you will be taxed on them at the end of the financial year.
If this is the case for your business, we recommend you set aside a certain percentage of your company profits in a separate business bank account to pay your tax liability when it is due.
Conversely, company owners will be paid a salary income, much like you would in any other kind of normal employment. This salary will be recorded as an expense to the business rather than drawing directly from the profits.
Salaried employees are personally liable to pay income tax rates and national insurance contributions.
Therefore, many small business owners pay themselves a smaller salary, which is then topped up with dividend payments for a more tax-efficient arrangement.
Of course, if you're ever unsure about how your business structure affects how you are paid and how your taxes work, it's always best to seek professional tax advice from a tax specialist or accountant.
While paying yourself a tax-efficient salary income may sound like the right arrangement, there's plenty of admin and additional costs involved. Therefore, always consult a professional accountant if you don't know which payment arrangement is best for you.
How To Pay Yourself As A Business Owner
Choosing to operate through a limited company as a business owner or consultant has a variety of causes.
In some cases, limited liability company owners will be looking for greater financial protection, while others will be looking for better benefits and personal tax allowances that limited companies provide compared to being sole traders.
Again, business owners within a limited company will most likely pay themselves a salary rather than drawing pay directly from their taxable profits.
Paying yourself a salary
However, while many business owners pay themselves salaries, there's a lot to consider before you embark on such an arrangement.
For starters, salaries in the UK are usually paid through the PAYE system, which goes straight to HMRC through the RTI (real-time information system).
Given that all the financial information you put into the PAYE system goes straight to HMRC, it's more beneficial for business owners to pay themselves a more modest salary in their remuneration package.
For example, HMRC and the UK Government allow you to earn up to £12,570 tax-free, known as the Personal Allowance upper earnings limit before the basic rate.
Earning up to this amount means you are ineligible for Income Tax bills, so you won't have to pay them.
Additionally, a salary of up to £6,396 will qualify you for National Insurance contributions and state pension contributions, as per the 2022-23 tax year regulations.
However, while you will have to pay some kind of tax when receiving a salary, the salary you pay yourself will count as an expense for your company, thus reducing the amount when you pay Corporation Tax.
Paying yourself via tax-efficient dividends
Dividends are a great way to top up your salary if you're choosing to pay yourself a modest amount for tax efficiency. Once your limited company has paid the relevant corporation tax bill, you're charged by HMRC. Whatever company profits you have left over can be distributed amongst your shareholders and owners.
While you will have to pay tax on your dividends, it's nothing like paying tax on a full salary through annual Income Tax.
Additionally, depending on the number of dividends you receive, you may be eligible for a tax-free dividend allowance. For the 2022-23 tax year, your tax-free dividend is £2,000, meaning you won't have to pay dividend tax rates on figures up to this amount.
Making contributions to your pension
Saving for the future by paying into a pension fund is another great way to improve tax efficiency. Limited companies are allowed to make pension contributions on behalf of their employees and directors.
However, the pension rules set down by HMRC are fairly complicated, meaning you may be better asking for professional assistance if you're unsure about what arrangements you can create
In a rough nutshell, once you pay a pension contribution for an employee or director out of your limited company, this contribution is considered tax-deductible so long as it falls within that individual's personal pension allowance.
Therefore, they won't be taxed on it until they come to draw down on their pension after retirement.
However, you don't even have to wait until retirement before you draw down on your pension pot. Under the current pension regulations, you can draw up to 25% of your pension tax-free.
You also have the annual pension allowance of £40,000 per tax year. If you don't use this allowance over a three-year period, all of these tax-free allowances can be used together.
This, therefore, offers you one of the most tax-efficient ways of extracting funds from a limited company in the future.
How much to pay yourself
However, it's all well and good talking about how to pay yourself as a business owner, but how much do you pay yourself? Essentially you are looking to find the right balance between the adequate earnings you and your household need to bring in and what is the most tax-efficient amount for your business. The easiest way to determine these two things is to perhaps think about what your business needs first.
For example, most small businesses will need:
Cash for deductible business expenses.
The best way to keep track of these is to create a list of the money you owe and when it is due to be paid.
This will prevent you from taking too much money out at once.
It is never a good idea to guess regarding your cash flow, as business owners are always tempted to over or underestimate their success.
Putting enough money aside to pay your taxes in full and on time is also prudent.
Cash for contingencies.
Like true love, the course of a successful business never runs entirely smoothly.
Therefore, keeping some money aside for any rough patches or business disruptions you encounter is always a good idea.
For example, you might want to keep a month or two's worth of expenses aside just in case something goes wrong, and you have to stop operating.
Cash for reinvestment.
Growing your small business should be your top priority once you're up and running.
A big part of this is keeping money handy for developing and improving your operations.
Eventually, you'll need to upgrade your equipment or tools, venture out on a new marketing campaign or bring in expert consultants.
Therefore, having some spare cash to cover these costs is always recommended.
Typical business owner salary or pay
Once you've worked out what your business will need in terms of ready cash, you can then choose what to pay yourself as the business owner. Again, many owners of limited companies choose to pay themselves a modest weekly or monthly salary that just covers their household expenses.
The remainder of the business's profits can then remain within your own limited company, covering any lost revenues or allowable business expenses. However, if your cash reserves start to pile up, you can always pay yourself a nice end-of-year bonus.
Therefore, you can see why it's so difficult to put an exact figure on what business owners should pay themselves. This is an entirely subjective figure, dependent on your own circumstances. Some owners may have large household expenses and therefore need a higher salary, while others will have successful companies that don't require too much spare cash.
With different businesses having different needs, it's tricky to know where yours might stand regarding salaries. However, in almost all cases, business owners usually have conservative salaries.
Tax-efficient business planning
While it's possible to run almost any small business in a more tax-efficient manner, the methods used to make these arrangements are not universally applicable to all businesses.
The tax rates that your salary and dividends will be subjected to are nothing to do with the tax benefits your company will receive through proper planning.
However, since you are the owner of the business, you can manage how and when funds are drawn from your business and how your taxes are timed.
This control over your company's finances is the most important thing to creating a tax-efficient business.
Another great benefit would be to have close family members working on behalf of your company, as you can also control these withdrawals.
Therefore, your limited company can be incredibly tax-efficient with the right salaries, pension contributions, and dividend payments, alongside the controlled distribution of your business's wealth between you and your family members.
Business health warnings
However, while it may sound like a rosy garden of delights creating a tax-efficient business, there are some tax pitfalls that you should be wary of. No matter how controlled and planned your company's finances are, if you fall into one of these traps, you're caught. Here are a few of the most obvious ones to look out for, but there are plenty more besides. Always speak to a professional accountant if you are worried about falling foul of these tax implications.
As a company director, you can't provide director's services from your company itself. You must have a dedicated director's address for correspondence. This address will appear on your PAYE salary, from which you pay your Income Tax, Pension and National Insurance contributions.
You can provide non-director services from your company address, but you will need a separate contract in order to prove this arrangement to HMRC. Additionally, you can work for one distinct branch or section of your company and be considered an employee rather than a director by HMRC.
However, if you undertake the above arrangement, your entire company will be liable for PAYE charges, National Insurance contributions and Employer's National Insurance on any payments it receives. Of course, you may be eligible for employment allowances as well.
The rules around dividends are also quite strict. For example, if HMRC believes that you are paying employees with shares and dividend payments on a monthly basis, they may choose to count this as a salary and tax it accordingly.
Her Majesty's Revenue and Customs also frown upon shifting profits. For example, if you own an 80% shareholder stake in your company but only receive a small salary, while your partner with a 20% stake receives a significant dividend payment, they will quickly challenge your limited company's financial arrangements and the director's salary.
There are plenty of other traps to look out for, including things like inheritance tax or capital gains tax on sold assets. You want to be careful when moving shares between family members or outsiders as well to remain on the good side of HMRC. Again, if you are worried or unsure about how to create the most tax-efficient business, always seek professional advice from expert accountants. Working closely with tax advisors and accountancy firms can turn your business into an incredibly tax-efficient financial vehicle.
It all depends on how your business is structured, which these professionals can help with. Again, not every method will work for every business, so it is best to wait until you know you won't be in breach of any rules or regulations before arranging your company in the most tax-efficient way.