Company Tax and Personal Tax

A simplified worked example

It’s important to be clear about what is company money and a company tax liability, and what is personal money and a personal tax liability. Let’s consider a simple example. To make the numbers easier to follow, we’ll also assume that corporation tax is 20% and that personal income tax is charged at 33% on dividends and 40% on salary. That’s close to the real situation for people who already have a mainstream job, and are also running a freelance business through their own limited company.

stacks and stacks of various new bank notes, batched into wads the way the bank does it

Do remember, that you and your company are separate legal entities. Each has its own assets and liabilities (money in the bank, and tax bills) and that it can often be the case that your company owes you money, or you owe your company money. Keep corporate stuff corporate and personal stuff personal. Maintain two tax reserves properly and then you’ll never get a shock when it’s tax payment time.

Dividend method

Mr Klavier is a music teacher at a good school with a good salary. He is already a higher rate tax payer even without having a business on the side. His business “The Piano Man Ltd” is a company, and it provides private tuition on a one to one basis in the evenings and weekends. All the fees go into the business bank account, and the company makes about £10,000 per year. The costs are negligible and so we can make a reasonable assumption that the company profit is £10,000 or as near as makes no difference. The company tax position looks like this:

Annual profit

10,000
Corporation tax at 20%

(2,000)
Distributable profit

8,000

Every year “The Piano Man Ltd” makes a profit of 10,000 and pays corporation tax of 2,000. If Mr Klavier does nothing else, then his company value increases by 8,000 every year until he shuts it down. The money stays in the company bank account. That way, the tax rate is effectively 20% all of the time, and there is likely to be a capital gains tax bill right at the end when the company is dissolved. Compared to income tax, capital gains tax is a cheap tax.

However, at the discretion of the directors (Mr Klavier is the sole director and the sole shareholder) a decision can be made to pay out some (or all) of the distributable profit as a dividend. A dividend is a reward to the shareholders for the original investment they made into the company. Normally, dividends are declared on a quarterly or annual basis. See the introduction to dividend vouchers for more detail.

This year, Mr Klavier decides to take all 8,000 of the distributable profit as a dividend. The 8,000 is transferred from the business bank account of The Piano Man Ltd to the personal bank account of Mr Klavier. As long as the company has enough money left to pay its own corporation tax bill, that’s OK. In real life you wouldn’t want to cut it that fine!

Knowing that he is a higher rate taxpayer, Mr Klavier needs to set aside something for personal income tax. Knowing that the dividend tax rate is 33%, he puts 2,667 of the 8,000 into a personal savings account and will pay that to HMRC later.

Using the dividend method, Mr Klavier is left with 5,333 as personal income. The overall effective rate of tax is about 47%. That’s more efficient than taking a salary from his company. The dividend rate of income tax is lower than the salary rate of income tax, because it allows a small measure of compensation for the fact that the company could only pay out a dividend, after the company had already suffered corporation tax.

Salary Method

Knowing that his company normally has 10,000 of income every year, Mr Klavier could decide to pay that out as a salary, and his company will need to set up an employer’s payroll account with HMRC. Salary paid to directors and employees is subject to PAYE at source, and the amount deducted each month includes national insurance (employer contribution at 13%), national insurance (employee contribution at 12%), and income tax (at the salary rate of 40%). Salaries are taxed at a higher rate than dividends. At first glance, that works out as 65% of some number. However, it’s a little better than that because the employer contribution of 13% has to be figured in before the headline rate of salary can be announced. A company with 10,000 available can offer a salary of only 8,850. That’s because 13% of 8,850 is 1,150 and this takes up the full quota of this company’s available cash. The employer contribution (the 13% NIC) disappears to HMRC before the commonly understood figure for salary can be established.

Then a smaller figure (the regular salary of 8,850) is subject to employee NIC at 12% and to income tax at 40%.

Annual income

10,000
Employer NIC at 13%

(1,150)
Headline salary

8,850
Employee NIC at 12%

(1,062)
Income tax at 40%

(3,540)
Net salary

4,248

The good news is that there is no 20% corporation tax to pay, because the company has no profit. The company income was 10,000. The allowable expenses (the gross salary) came to 10,000 and the remaining profit is NIL.

Using the salary method, Mr Klavier is left with 4,248 as personal income. The combination of income tax and National Insurance contributions leads to an effective rate of tax of 58%.

Additionally, the government will silently thank Mr Klavier for swelling the coffers of The Exchequer.

Comparison

20% or 47% or 58%

If you roll up all of the company money in the business bank account, you can pay no more than 20% corporation tax. However, there will be some capital gains tax to pay when you finally stop trading. Be warned, HMRC does not like you doing this, because you are not be commercial. They are right, the Companies Act 2006 requires you to run your business on a commercial basis, and businesses are generally not in the business of sitting on mountains of cash waiting for the director/shareholder to retire.

So you should extract a commercially viable figure. As dividends or as salary. You probably need to do that anyway, in order to live! You need personal money. The company money is not your money.

Do you want to pay a combined tax bill at an effective rate of tax of 47% or 58%? Will the government use your extra tax payments wisely?

More importantly, if you go down the salary route, do you want the extra admin of running an employer’s payroll account and making monthly remittances of PAYE to HMRC? Or, perhaps incurring the cost of engaging a payroll bureau to do the admin for you?

By running a payroll you can do tedious admin, pay more tax overall, and impede your cashflow.

It’s your call, it’s your business and you are the director/shareholder. What does your business plan say about remuneration? What does your strategy say about maintaining corporate and personal tax reserves?

 

Director shareholder payments 2021/22

This is a basic guide to the small salary big dividend method of rewarding yourself from your own company for the tax year ended 5 Apr 2022.

Your company is responsible tor maintaining a corporation tax reserve. Dividends can only be paid from the company’s post tax profit, so that means that the company tax reserve must stay in the company.

If you have no profit, then you can pay no dividend. Take care not to pay dividends out of investor funding or out of bank loans. Investor funding and bank loans are not “profit”.

When most of your income is from dividends then you will need a personal income tax reserve as well. Keep corporate stuff corporate and personal stuff personal. Maintain two tax reserves properly and then you’ll never get a shock when it’s tax payment time.

Follow this system precisely. Ensure bank transactions between your company bank account and your personal bank account follow this system accurately. If it’s not right then HMRC may decide that PAYE tax and National Insurance is due on all of your personal income. You definitely do not want that to happen.

For this process to be legitimate you must be a director/shareholder of a UK limited company.

Your salary is paid to you for the responsibility involved in “holding the office of director” and not for “work done”.

All shareholders must receive dividends in direct proportion to their shareholding.

Beware of adverse consequences if you decide to take 100% of the dividend when you are not the 100% shareholder.

Other than salary, describe these amounts as “drawings” until the overall tax picture for the year is clear. The “dividend” is calculated later. Separate bank transfers are required in order to distinguish salary from drawings. In most cases that means setting up 4 separate payments at end of every calendar month. As Proactive does not hold any authorities on client bank accounts, it’s up to you to make the correct transfers at the correct time.

Basic rate taxpayers

For people whose monthly income does not exceed 4,188.

Basic rate taxpayers year ended 5 Apr 2022
Monthly figures
Salary 736
Primary “Tax Free” drawings (personal allowance) 311
Secondary “Tax Free” drawings (dividend rate band) 166
Tertiary drawings (max) liable to 7.5% tax 2975
Provided always that the monthly income does not total more than 4188
Put aside 7.5% of your tertiary drawings as a personal tax reserve.

Higher rate taxpayers

For people who need (and can afford) monthly incomes between 4,188 and 8,333.

Higher rate taxpayers – 40% year ended 5 Apr 2022
Monthly figures
Salary 736
Primary “Tax Free” drawings (personal allowance) 311
Secondary “Tax Free” drawings (dividend rate band) 166
Tertiary drawings liable to 7.5% tax 2975
Supplementary drawings (max) liable to 32.5% tax 4145
Provided always that the monthly income does not total more than 8333
Put aside 7.5% of your tertiary drawings as a personal tax reserve.
Also put aside 32.5% of your supplementary drawings as a personal tax reserve.

Top rate taxpayers

For people who need (and can afford) monthly incomes in excess of 8,333.

There are graduated changes for annual incomes between 100,000 and 150,000 and the 45% rate of income tax also kicks in.

Top rate taxpayers – 45% year ended 5 Apr 2022
Monthly figures
Salary 0
Primary “Tax Free” drawings (personal allowance) 0
Secondary “Tax Free” drawings (dividend rate band) 166
Tertiary drawings liable to 7.5% tax 2975
Supplementary drawings liable to 32.5% tax 5192
Additional drawings liable to 38.1% tax excess over 8,333.00
Put aside 7.5% of your tertiary drawings as a personal tax reserve.
Also put aside 32.5% of your supplementary drawings as a personal tax reserve.
And put aside 38.1% of your additional drawings as a personal tax reserve.

Is this legal?

Yes.

Lord Tomlin stated in the case of IRC vs Duke of Westminster (1936) 19 TC 490 every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be.

The key thing is to keep this system in “order” and in compliance with the various Taxes Acts. If you deviate from the guidance above then you may find that your tax planning is not legal.

How much can I draw?

Director/shareholders of UK limited companies tend to reward themselves will a small salary and a dividend. The recommended system for 2021/22 is set out here.

However, in order to get the calculations absolutely right you need to know how much profit the company has, and you probably won’t know that until after the year end accounts have been done. So, part way through a trading year we don’t call these figures “dividends” and we suggest that you take “drawings” in the expectation that a dividend can be declared.

As a rule of thumb you can calculate your drawings using this method. It ignores some fine detail of accounting, but it will get you through to the year end.

Set up a separate company bank account for your company to hold its tax reserve. That’s for corporation tax and (if you’re VAT registered it’s also) for VAT. One savings account is enough.

When a client pays you, put aside 20% of that fee as a provision for corporation tax. Also put aside all of the VAT you charged on that invoice. OK, that ignores allowable expenses and things, and it will be a little too much, but it’s better to have too much tax reserve than too little.

What are you left with, net of corporation tax and net of VAT? Maybe knock off something for expenses as well. Then you have some idea of what the company can afford from its “distributable” profits.

Use that notional figure, and that’s the maximum drawings you can take.

At the end of each quarter, when the bookkeeping reports (and the VAT reports) are done, have a look at your balance sheet. It shows you a forecast of the corporation tax (and the VAT), along with the bank balances on that quarter end date.

In the example above, the tax reserve (in bank account number 2) is £9,000 and that’s £505 more than the total tax forecast of £8,495. This is a good thing.

To the extent that your savings account balance (on the quarter end date) exceeds your creditors balance (on the quarter end date), then you have over provided for tax. If you want to, you can take that excess and move it back to the current account to employ the funds usefully in the business. Or if it’s the other way around, please take steps to restore your tax reserve to its rightful level.

Over time, you might want to adjust that 20% rule down to 19% or 18%. It will take several quarters before you get a feel for what is the right percentage in the case of your own company, and it will depend on having like for like activity each quarter. You’ll know when you hit the right percentage when, every quarter, the excess/deficit on the savings account is consistently small enough to make little difference.

As long as your name does not already appear under “creditors”, then the balance sheet may also show you what the maximum available amount of “distributable” profit is. Assuming that a director’s name does not feature on the balance sheet, then the example above shows that £1,554 is available. That’s just above the bottom line “total funds” figure, and it’s what the company is worth once you ignore the “share capital” line.

If your name is in the “creditors” block then a bit more arithmetic is needed. Firstly, don’t be in that territory on the quarter end date, and secondly, ask your accountant to tell you where you actually stand.

Please do not draw out more than the company can afford. If you do, then HMRC will seek retribution, and they will seek seriously penal levels of tax. We will tell you every quarter when you’re in the danger zone.

I have too much profit, what can I do about it?

This is a fantastic question and we hear it from time to time:

“I have too much profit, what can I do about it?”

It is however a coded version of something else, and it can mean either:

• I don’t have enough profit. I know that, because I have drawn all the money out of my business and I have nothing left to pay my tax bill (and so you must magically engineer a smaller profit for me and a smaller tax bill)!

• I have ridiculously large sums of money floating around, even after paying all my tax bills, I have the home of my dreams, the car of my dreams and I fly everywhere first class, and now I’m in danger of taking up a ridiculously expensive hobby like round-the-world yacht racing!

Depending on which of those statements is the closer to the truth, then the solution is either:

• Make more profit and manage your tax reserve on a weekly or monthly basis. In the short term, borrow some money so that you can pay your tax bill. See Zopa for more details of how you can borrow modest amounts of cash at reasonable rates. We are not in the business of engineering false sets of accounts.

• Become a business angel and invest! There are entry level ways of doing this, even if the pool of cash is as low as £1,000. See Zopa for more details of how you can become an ultra cautious business angel.

If you would like to make more profit, then you need good business advice. Call us and ask about business coaching – we will start by asking you for a copy of your business plan.

Or you can start by looking at Don’t Read My Blog.

The VAT only invoice

Sometimes an application for VAT registration can be delayed, and you end up completing work after the VAT start date you asked for, but before the VAT number is known.

You cannot charge VAT to a customer until you have your certificate of VAT registration and you know the VAT number.

If you can delay your first invoices then that’s easier, but you may want to invoice in order to collect the fees first, and to collect the VAT later. You should keep you customer informed of this dilemma.

In situations like these, it becomes necessary to issue a later “VAT only” invoice as soon as the VAT number is known.

There are several examples of invoices on this Excel file and the final one shows you how to set out a “VAT only” invoice.

When sending it to the customer it’s best to remind them that you are simply following the HMRC rules. You have a legal duty to do it this way and they have a legal duty to pay you the VAT!

Independent Financial Advisors

Proactive is not authorised to provide financial advice, pension advice, mortgage advice, nor to make recommendations about products or companies. We can advise on the tax implications of your intention to act on any advice which you may have received.

The financial advisors you meet are in the business of running a business. They may be trying to find you a good deal, but more importantly they will be trying to find themselves a good deal. The accounting forums are littered with horror stories of advisors putting people into the wrong products, purely because that product gives the advisor a better commission. Additionally, some IFAs tend not to understand the Inheritance Tax implications of products and strategies they advocate.

They’re not doing this for your benefit, they’re doing it for their benefit.

The accountancy profession does not hold IFAs in high esteem. The running joke is “What does IFA stand for? Idiot Financial Advisor”. At Proactive we’ve met a few over the years, but none that we could recommend! It would be nice to find a reliable, ethical one.

When you choose an advisor please establish early on whether they charge you a fee or take a percentage from the Finance House (the pension company, the lender, etc). Check what that figure is. You are more likely to get independent advice if you pay the advisor’s fee, rather than the Finance House.

To give you one example, if a commission based advisor places your business with a Pension House then the commission the advisor receives is roughly equivalent to the pension contributions you pay over the first 24 months of your policy.

If you engage an advisor, expect to start with a lengthy “financial health questionnaire”. In the days of paper, these used to run from 10 to 30 pages of A4. It’s worth your while completing this fully and accurately in order that there can be no misunderstanding about the information the advisor can rely on.

For example, over the last few years there has been a lot of pension mis-selling and this could give rise to a claim for compensation. Even if the financial advisor who sold the pension is no longer trading, then the Finance House can be pursued. That means that you will need a copy of the “financial health questionnaire” if you want to prove any case of negligence.

Any financial advisor who does not start with something like a “financial health questionnaire” is well worth avoiding.

In support of your request for advice, your advisor may ask you to provide copies of your personal tax calculation (a form SA302), copies of your personal tax overview (a summary from the HMRC website), and for people who run a freelance business, copies of the formal accounts. That’s all perfectly reasonable and any accountant should be able to provide that. At Proactive we routinely prepare these documents, generally we have them ready long before they are needed, and we can then let clients have them within seconds, not hours, not days, not weeks.

HMRC has been working with the lending industry on the issue of documentation and has reported that the number of requests for additional evidence has declined significantly. But, they add, that the message has not yet filtered down to all staff in all relevant “financial advice” organisations.

If your advisor questions the veracity of the documents you/we provide, then find a different advisor or work directly with a lender . HMRC has published this useful list of lenders who accept your own documents:

https://www.gov.uk/government/publications/ . . .

Note that the HMRC page says “The lenders on this list have agreed to accept tax calculations and tax year overviews that customers, or their agents or accountants, have printed themselves.”

In the light of this information, if your advisor still refuses to accept these documents and continues to question their content, then they are in effect accusing you, or accusing us, of fraud. A properly completed “financial health questionnaire” along with the form SA302, the tax overview, and the formal accounts is all that they need.

Not since 1988 has a personal tax return had a section for “chargeable assets acquired”. As a result, we do not routinely maintain an overarching asset register of clients’ properties and investments, and we cannot answer questions about those assets. The decision to stop maintaining an asset register was a time saving measure implemented by us donkeys years ago. Subsequently, the GDPR (see below) would have forced that decision upon us anyway!

Subject to de minimis limits, a personal tax return does have a section for “chargeable assets disposed of” and hence we do sometimes seek further information about “chargeable assets acquired” in order to calculate capital gains tax liabilities. Our record keeping strategy follows Einstein’s advice:

“Make everything as simple as possible, and no simpler than that.”

It’s simple. Banks need to lend, like birds need to fly.

Banks that do not lend will fail. Pension Houses that cannot sell pensions will fail. IFAs that cannot offer intelligent financial advice will fail. Some IFAs make the simple task of getting a loan from a lender far more complicated than it needs to be. That’s why we advocate dealing with the lender directly and cutting out the middle man.

All these financial institutions, IFAs and accountants included, need to follow the KYC rules (know your client rules) mandated by various bodies including the Financial Conduct Authority (FCA).

At the same time, we all have to comply with the GDPR. In particular, under Article 5, the amount of data that can be requested is restricted to the minimum needed to do the job.

General Data Protection Regulation 4.5.2016

If your IFA is too enthusiastic about gathering too much data, then please point them to this report on this Proactive website! If they say “it’s our policy” to ask more questions, then please respond with “may I have a copy of that policy document in order that I can fully understand the policy?” and then if the policy document does not exist, or is “for internal use only”, the IFA has something to hide.

“Article 5 – the amount of data that can be requested
is restricted to the minimum needed to do the job”

A properly completed “financial health questionnaire” along with the form SA302, the tax overview, and the formal accounts is all that is needed. If your IFA has not asked you for (or cannot interpret) a properly completed “financial health questionnaire” then you need a different IFA. Likewise, if your IFA cannot read and understand a set of statutory accounts, then you need a different IFA.

We will genuinely help in cases where it is within our power to do so. When we face questions which are outside the remit of the role of the accountant, then we genuinely cannot answer those questions.

“Make everything as simple as possible, and no simpler than that.”

I cannot afford to pay a salary

In the early days of a business, it may be advisable to pay yourself a small salary, even if your company cannot really justify the cost. The reason is tax relief. And, as tax reliefs are linked to tax years and as tax years end every 5 April, once the tax year has gone the opportunity to get the tax relief is lost.

This example uses 2020/21 figures.

Paying a salary from a company is an allowable expense. All things being equal, your company will get 19% tax relief on that. And so, for every £1,000 you pay in salary, your company tax bill is reduced by £190.

In the hands of the company director, the salary is taxable income. However, as there is an annual allowance for personal income, you may be able to take a salary and pay no income tax.

• Monthly salary £732.00
• Annualised £8,784.00
• Corporation tax relief £1,668.96
• Income tax bill £nil

It’s worth a lot of money to your company to take a salary. And if that means orchestrating a loss in the company this year, you can still carry forward the loss, and get the tax relief when the company next has a profit. You cannot carry forward unused personal allowances, and that is why you need the salary in any given tax year.

In some cases that means that the director introduces working capital to a company every month, so that it can pay the salary – in effect, moving about £750 around in circles. That’s OK. The director can receive the salary tax free, and at some point in the future (when the company has the cash) the director can recover all the multiples of £750 which have been loaned to the company.

And it has to actually happen! You cannot say “it happened” at a later stage, if it did not! HMRC have been known to ask for the bank statements to see the exact amounts and the dates on which the bank transfers took place!

It might be worth it, if it saves you around £1,700 per year overall!

Example Letterhead and Invoices

All businesses should prepare standardised documents for their correspondence and invoices. An invoice is basically a standard letterhead with the addition of a number of billing points. The examples set out here assume that your business is a limited company.

If you are a sole trader or if you operate as a partnership, you can ignore the bits about a company registered number and registered office address.

Your trading address must be included in all cases. If your company registered office and your principal place of business are one and the same, that you only need to show the address once, provided that it is clear that they are one and the same!

Example Letterhead

Example Invoices

You can only use a VAT invoice if you are VAT registered. The Excel file has an example of a non-VAT invoice on tab 1 and an example of a VAT invoice on tab 2. Please use the correct one.

There are strict rules about invoicing by VAT registered businesses. They are set out in detail at:

Reg 14(1)(i) The Value Added Tax Regulations 1995

The letterhead legislation is set out here and it includes a requirement that you show these details on your web site and somewhere within your emails:

The Companies (Trading Disclosures) Regulations 2008

and

The Companies (Trading Disclosures) (Amendment) Regulations 2009

Student Loan Statements

In July 2020 the Student Loans Company emailed everyone on their records to say that they will no longer send out paper statements like this example.

They claim that you can get this data from their new web site. You cannot.

Write to the Student Loans Company using a traditional paper letter, and tell them that you want to opt in to receiving paper statements because your accountant needs precise data for every tax year. Use the form of words below and (if necessary) adjust the tax year for the one just ended.

Thank you for your email dated 14 Jul 2020 which states “We’ve listened to your feedback and created a quicker and easier way to view your student loan balance, update your personal details and get information about your loan”. I logged in to the portal to get information about my loan. In order that I can complete my self assessment tax return I need an annual statement which provides a clear analysis of:

• the balance on 6 Apr [old year]
• the monthly rates and the amounts of interest charged
• credits received from HMRC
• the balance on 5 Apr [recent year]

Your site provided me with none of the above, and no way to find that data. My accountant needs this information. Your email also states “With our new service you’ll be able to view and print a copy of your annual statement“. Your new service does no such thing.

The new portal is worse than useless. I want to opt back in to receiving paper statements. Please let me have a paper statement setting out the precise details listed in my four bullet points above. Thank you.

Feel free to copy the image file above and embed that in your letter, so that they are in absolutely no doubt about what we want.

The Abatement Dilemma

You may have to pay more income tax if your annual income exceeds £100,000 as a result of the abatement of the annual personal allowance. The allowance is gradually reduced until it is eliminated in full.

The annual personal allowance is:

2018/19 – 11,850
2019/20 – 12,500
2020/21 – 12,500

Once your “adjusted net income” exceeds £100,000 your personal allowance is reduced by £1 for every £2 of income over and above £100,000.

For example

If in 2019/20 you have income of £120,000 and make (gross) pension contributions of £5,000 then your adjusted net income is £115,000.

It’s over the £100,000 limit and so the annual personal allowance is reduced. The £12,500 is reduced by £1 for every £2 by which your income exceeds £100,000.

The reduction in the personal allowance is therefore £7,500 (half of (£115,000 minus £100,000)).

The personal allowance for 2019/20 becomes £5,000.

The 60% tax zone

When your net income falls within the zone in which the personal allowance is reduced (that’s from £100,000 to £125,000) then the marginal rate of tax is 60%. This is the combined effect of the application of the higher rate of tax and the reduction in the personal allowance. Currently for 2019/20 the upper end of the band is £125,000 but that may not be true for other years, the strict upper limit is £100,000 plus twice the personal allowance.

Stealth Tax

Abatement was introduced on 6 Apr 2010 when the threshold was set at 100,000. Almost every year the annual person allowance goes up and tax rate bands are adjusted. However, the abatement threshold has never changed. This means that over time more people are becoming liable to 60% tax. If your employment or self employment income is over 100,000 then there is  National Insurance at 2% as well. Don’t let anybody tell you that the highest rate of tax in the UK is 45%, it’s 62%.

Options

There are three options, none of which is easy:

1. Pay the tax
2. Reduce your income below £100,000
3. Increase your income so much that a mere 62% on a 25,000 tranche of your income pales into insignificance.

Don’t dismiss that last one. All you need is a plan. What does your business plan say?