Limited companies become individual legal entities when they are incorporated at Companies House. This means that all business finances and assets belong the company, not the owners of the company. For this reason, you cannot simply remove money from the business in the same way as a sole trader can.
You have to follow specific procedures to record and account for all money going into and out of the company’s bank account. It is important that you do not remove more than the profit that remains after tax and other financial liabilities have been accounted for.
The four ways you can take money out of a limited company are:
- A director’s salary
- Dividend payments
- A director’s loan
- Claiming expenses
By extracting profits using a combination of these methods, a limited company can be an extremely tax-efficient way to run a business and minimise personal tax and National Insurance liabilities. This is because a company’s taxable income (profits minus costs and overheads) is liable for only 19% corporation tax, as opposed to Income Tax of 20% – 45% that sole traders have to pay.
Income Tax rates for 2017-18:
- 20% on taxable income up to £33,500
- 40% on taxable income between £33,501 – £150,000
- 45% on taxable income above £150,000
1. Director’s salary
Company directors, many of whom are also shareholders in a business, usually receive a salary from the company. Directors are essentially employees, so the company must register with HMRC for PAYE and pay employer’s National Insurance Contributions (NIC). The company must deduct Income Tax and Class 1 NICs from the director’s salary every pay period and pay this money to HMRC on a monthly or quarterly basis.
A salary is a tax-deductible expense that is paid out of company profits before corporation tax, so companies do not pay any tax on this money. Directors can pay themselves efficiently by taking a salary up to the NIC primary threshold (£8,164 for 2017-18) but below the personal allowance limit (£11,500 for 2017-18), therefore incurring no personal tax liability but still qualifying for state pension and benefit entitlement.
If a director is also a shareholder, additional income can be taken out of the company as dividends, which are paid from company profits after the deduction of 19% corporation tax. There is no tax liability on dividends up to £5,000 per year. Above that amount, you will pay the following dividend tax rates as per your income tax band
- Basic rate: 7.5% up to £45,000 annual income
- Higher rate: 32.5% between £45,001 – £15000 annual income
- Additional rate: 38.1% above £150,000 annual income
Sole traders would pay a great deal more in Income Tax and National Insurance on the same amount of taxable annual income.
Dividends are paid to company shareholders out of profits. This is after the deduction of all costs, expenses and business taxes for the current financial year, and after taking into account any retained profits and loss from previous financial years. If there is no available profit after these considerations, a dividend payment will be classed as an illegal dividend, which could result in an HMRC investigation and penalties.
All dividend income received by an individual will be taken into account for Income Tax band purposes. When an individual’s annual income exceeds the basic rate threshold, dividend payments will be liable for the higher and/or additional dividend tax rates. And remember: companies pay 19% corporation tax on their profits before dividends are paid to shareholders, so it is important to be wary of the pitfalls of higher tax rates.
Dividend Tax Calculator
3. How to issue a dividend
A limited company can issue interim dividends throughout the year, or final dividends at the end of the financial year. Most small companies will issue interim dividends because the owners of small businesses usually rely on this regular income.
To issue a dividend, it must be ‘declared’ by the company directors at a board meeting and a payment date should be agreed. A dividend voucher must then be issued to each shareholder, which should state the following:
- Date the dividend was declared
- Company name
- Shareholder’s name
- Payment amount
Divided vouchers are usually issued on the date the payment is declared. Minutes of these board meetings must be taken, even if a company has only one director, and copies of minutes should be kept at the registered office or SAIL address.
4. Director’s loan and director’s loan account
A director’s loan can be a tax-efficient way to remove money from a company. The purpose of a director’s loan is to allow a director to borrow money from a company or a company to borrow money from a director. These transactions must be recorded in a director’s loan account, which can be any form of a bank account or bookkeeping entry.
A loan account will record a running balance of all money paid to or removed from a company by a director – account balances will show as ‘in credit’, ‘nil’ or ‘overdrawn’, in much the same way as a personal current account with an overdraft facility.
- A director borrows money from a company that exceeds the amount he or she has given to the company. The loan account will be ‘overdrawn’ until the loan is repaid in full or written off by the company.
- A company borrows money from a director. The loan account will be ‘in credit’ until the director reclaims the money he or she gave to the company.
- No money is owed by a director to the company or by the company to a director. The loan account will have a balance of ‘nil’.
There may also be tax implications for a director and a company, depending on the overdrawn balance and the period of time the account is overdrawn. If a company owes money to a director, a director can remove this sum from the loan account at any time without facing any tax liabilities.
All transactions in a directors’ loan account must be accounted for in a company’s balance sheet. They may also have to be included in the Company Tax Return and director’s Self Assessment tax return. Tax liabilities for overdrawn accounts depend on the amount of money a director owes to the company, or vice versa, and the length of time the loan account has been overdrawn.
In most cases, there will be no tax implications for a director if an overdrawn loan account of £10,000 or less is repaid within 9 months and 1 day from the end of the company’s accounting reference date (ARD). If the overdrawn loan is not repaid within that time, the company may have to pay 25% of the outstanding amount as corporation tax.
If a director owes a company more than £10,000, this sum must be declared on his or her Self Assessment tax return, and the official rate of interest may be applied. Companies and directors may also charge interest on any sum of money owed to them.
A loan from a company to a director is classed as a ‘benefit in kind’. Class 1 National Insurance must therefore be deducted through payroll. If a company writes off a director’s loan, the director must pay Income Tax on the loan amount through Self Assessment because the loan is treated as a form of taxable income.
When a director lends money to a company, he or she can charge the company interest on the loan amount. If interest is charged, this will count as a business expense for the company and a form of personal income for the director. The director will be required to report this interest as income on his or her Self Assessment tax return. If no interest is charged by the director, the company will have to report the loan on the Company Tax Return.
5. Leaving surplus profit in a company
The flexibility of a limited company structure allows you to leave surplus income in the business and with-drawn in a future financial year. This is a great option if removing this money would result in a higher personal tax rate or dividend tax rate in the current financial year. This option is not available to sole traders.
6. What tax do company directors pay?
Company directors pay Income Tax and National Insurance Contributions on their total annual income. These deductions are paid directly to HMRC through PAYE (and Self Assessment if the director receives income other than his or her salary). The Income Tax on a director’s salary and Class 1 NI are collected through payroll by the company and paid to HMRC along with the company’s NI contributions as an employer.
If a director receives part of his or her income as dividends, no National Insurance will be payable on that income. This will result in a saving for the director as well as the company. If a director is a higher rate taxpayer, he or she may have to pay a higher rate of tax on dividends.
7. Self Assessment for company directors
Directors must register for Self Assessment and complete Self Assessment tax returns with details of their income from all sources. If a director owes more tax than the company has collected through payroll and paid to HMRC (for example, dividend payments and benefits received), the director must pay the additional tax through Self Assessment. Full guidance on Self Assessment for employees is available here.
8. Reporting an overdrawn director’s loan on Self Assessment
There are certain tax implications for directors and limited companies when a loan account remains overdrawn or in credit for a certain period of time. Interest rates are applied in some circumstances.
Companies may be required to include details of directors’ loans in their Company Tax Returns and paying tax under Section 455 of the Corporation Tax Act 2010.
Directors may have to include details of these loans in their Self Assessment tax return and pay Income Tax on loans that have been written off or on interest received from the company.
When to report a director’s loan on your Self Assessment tax return
Directors must report loans on their Income Tax Self Assessment tax returns in the following circumstances:
- The director owes the company more than £10,000 at any time during the year.
- The director pays the company interest on a loan below the official rate of interest.
- The director is not required to repay the loan because it is ‘written off’ or ‘released’ by the company.
- The director charges the company interest on a loan, which is classed as a form of personal income.
There are a number of circumstances when directors’ loans and interest payments are viewed by HMRC as forms of taxable income. Therefore, directors will be liable to pay Income Tax and National Insurance Contributions on these loans or payments.
We strongly advise consulting an accountant or tax advisor to assist with matters relating to directors’ loans and Self Assessment tax returns, particularly if you have no prior experience with such matters.
By Chris Tapley, Content Writer for 1st Formations.