An Essential Tax Planning Guide for Business Owners
When you own a business, your personal financial plan should be at the heart of every decision you make. Once you know how much money you need for everyday life and your long-term aspirations, you can consider how your business plan can work alongside your financial plan to provide you with the lifestyle you require.
The success of your business will depend on the quality of your product, your reputation in the market and an appropriate pricing strategy. Sensible tax planning can help to maximise your profits and ensure that your hard work pays off.
Which Business Structure?
There are three main business structures:
· Sole trader
· Partnership
· Limited company
Sole traders and partners are taxed personally on business profits. The rates of tax range from 20% - 45% (19% - 46% in Scotland) and there is no option to defer taking profits in order to reduce your tax bill. National Insurance is payable in addition.
There is also usually no separation between the business and your personal affairs, which can be bad news in the event of bankruptcy or if someone takes legal action against you. Some limited liability partnerships offer a degree of protection, but legal advice is recommended.
A limited company is a completely separate entity, so there is some separation of personal and business assets. Income can also be structured more tax-efficiently (see below).
The main disadvantages of a limited company are:
· Increased reporting requirements
· Higher costs. For example, most companies require the services of an accountant.
However, all but the very smallest of businesses are likely to see a saving via the limited company structure.
Drawing Your Income
A limited company provides greater flexibility when it comes to structuring your income. Most company directors take a basic salary within their tax-free personal allowance. The rest of their income is drawn via dividends, or a share of the company’s profits.
While dividends are declared after the deduction of Corporation Tax, the first £2,000 of dividend income is free of tax. Shares can be allocated between spouses (or even gifted to children) to maximise this allowance. The remainder is taxed at 7.5% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers.
This is slightly more tax efficient than drawing profits on a self-employed basis. But there are two other benefits that make an even bigger difference:
Self-employed income is subject to National Insurance at a rate of 9% on earnings between £9,501 and £50,000 (2020/2021 tax year). Income above this level is charged at 2%. Dividends are not subject to National Insurance Contributions which can result in a significant saving. Even better, providing you draw a salary of at least £6,240, you will accumulate NI credits and build up entitlement to the State Pension.
Dividends are only taxed when you actually declare them. In a particularly profitable year, it’s possible to hold back some of the earnings and pay the dividends in a later year.
Company directors can also use director’s loans to take income tax-efficiently. For example, if you invest a significant amount in a company, you can reclaim what you are owed, without tax liability, as the company starts to generate a profit.
Allowable Costs
Most business owners understand that they can claim for costs against their tax bill. Supplies, stationery, and services such as IT and accountancy are all eligible. As your business grows, rental expenditure and staff costs are also allowable.
Some other allowable costs are:
· Interest on business loans
· Life insurance for yourself and your employees
· A mileage allowance of 45p per mile for business travel (25p per mile above 10,000 miles)
· Company events, such as a Christmas party (capped at £150 per person)
· Costs incurred by working from home
Capital allowances are also available on investment in the company, for example, on machinery, vans, and computer equipment.
Certain items are not allowable, for example:
· The cost of getting to work
· Entertaining clients
· Childcare
· Fines
Maximise Your Pension
Pensions are possibly the most tax-efficient method of saving for retirement. While many business owners think of their business as their pension, there are strong reasons in favour of using both. For example:
· Pension contributions are an allowable business expense.
· Unlike personal contributions, company contributions are not limited by your earnings. However, they must be deemed reasonable, and ‘wholly and exclusively for business purposes.’ A director making a £40,000 pension contribution from a profitable company would most likely be allowable. Making the same contribution for a part-time employee, who also happens to be a family member, probably wouldn’t be.
· A pension allows you to build up wealth outsid
e the business, which cannot be accessed by creditors if the business becomes insolvent.
· Certain types of pension scheme can also make loans to the sponsoring employer, or be used to purchase commercial premises. This is a complex area and advice is strongly recommended.
· During the transition to retirement, it can be efficient to combine pension income with dividends to make the most of tax allowances.
Business Succession
Eventually, you will need to think about what will happen to the business when you no longer wish (or are no longer able) to run it.
Depending on the route you take, there are various tax reliefs available:
Selling the Business
When you dispose of an asset, including a business, you will pay Capital Gains Tax on the gain you have made.
Capital Gains Tax is normally charged at a rate of 10% for basic rate taxpayers and 20% for higher rate taxpayers. When selling a substantial asset like a business, most of the gain would usually fall into the higher rate tax bracket.
However, Entrepreneur’s Relief means that CGT is capped at 10% on the first £1 million of lifetime gains from business sales.
Passing the Business On
You may prefer to pass the business on to your children. This will normally benefit from ‘holdover relief.’ This means that no Capital Gains Tax is payable at outset, but if your son or daughter eventually sells the business, they will pay CGT on your gain as well as their own.
The business can be passed on as an outright gift, or by gradually transferring shares over time.
Remember, gifts remain within your estate for Inheritance Tax purposes until seven years have elapsed.
If You Die
If you die, the business can usually be passed on to the next generation with 100% Business Relief from Inheritance Tax.
Remember that Business Relief will be lost if you sell the business. There are some options for reinvesting the proceeds that will continue to qualify, however these are usually relatively high risk, and are not suitable for everyone.
Business taxation is a complex area and some of the reliefs available are subject to a lengthy list of conditions. It is recommended that you seek professional advice.
Please don’t hesitate to contact us if you would like to find out more about your tax planning options.
