Your Limited Company - How Does It All Work?
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Limited Company - How Does It All Work
The common misconception when someone sets up a limited company is the belief that they are the limited company. This is not so. Limited companies become individual legal entities when they are incorporated at Companies House. This means that all business finances and assets belong to 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 must 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 you ensure that other financial liabilities are covered. Otherwise, you get into difficulties, HMRC will have a field day and we can only do so much.
How Do You Take Money Out Of A Limited Company Then?
Subject to IR35, the ways you can take money out of a limited company are:
Charge interest to the company on any credit balance on a Director’s Loan account.
Drawing down monies which you have paid into the company or expenses paid on behalf of the company apart from any monies paid in for share capital.
By extracting profits using a combination of these methods, a limited company can be a tax-efficient way to run a business and minimise personal tax and National Insurance liabilities provided that IR35 does not apply. 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% and Class 2 and 4 National NIC that sole traders have to pay. Tax is payable on dividends extracted in excess of £5000 (£2000 for 2018/19 onwards).
We do not recommend that monies are drawn out in any other way as this could create an overdrawn director’s loan account (see below).
IR35 is designed to stop employers/employees avoiding PAYE and NIC on earnings. If there is a contract of service between your company and its customer(s) then it is likely that the company would be liable to tax and NIC under IR35. If this is the case then we advise that at least 95% of the net payments under a contract of service are paid as salary to the director(s) under PAYE and NIC so that no payments are then due under IR35. 1 to 4 below would not apply.
From 6th April 2017, Public Sector Bodies are required to deduct PAYE and NIC from payments made to companies which are subject to IR35.
If there is a contract for service then IR35 should not apply and the profits not subject to IR35 can be extracted as follows:
1. Director’s Salary
Company directors who are employees of the company and may also be shareholders in the company. Usually a salary will be paid in which case the company will normally need to register with HMRC under RTI. A salary is a tax-deductible expense provided that it is paid wholly and exclusively for the benefit of the business. If the director is also a shareholder, it is usually more efficient to take a salary between the NIC primary threshold (£8,164 for 2017-18) and 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 the company only lets property it may not be possible to justify the payment of such a high salary.
Provided 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 (£2000 per year from 2018/19). 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 - £150,000 annual income
Additional rate: 38.1% above £150,000 annual income
There is no National Insurance to pay on dividends
Sole traders would pay a great deal more in Income Tax and National Insurance on the same amount of taxable annual income.
How To Issue A Dividend
Before a dividend can be paid, a company needs to ensure that it has distributable profits. This will either be available from the last accounts or it will be necessary to draw up management accounts.
Subject to the above, 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 (which should be minuted) and a payment date should be agreed. A dividend voucher should then be issued to each shareholder which will state the following:
Date of dividend
3. Pay The Director On A Credit Loan Account
The director can charge the company interest on a loan, which is classed as a form of personal income. For the interest to be allowable against the company’s profits, it would need to be charged at a commercial rate. The company must deduct tax at 20% and account for this on form CT61. The director would then declare this to HMRC and could set the personal savings allowance of either £1000 if he was a basic rate tax payer or £500 if he is a higher rate taxpayer against the gross interest. Additional rate taxpayers receive no allowance. Higher rate tax/additional rate tax would be due if applicable. Any tax overpaid would be repaid. There is no National Insurance to pay on interest.
4. Leaving The Surplus Profit In A Company
The flexibility of a limited company structure allows you to leave surplus income in the business and withdraw 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.
What Tax Do Company Directors Pay?
A director must register for Self-Assessment and complete a Self-Assessment Income Tax Return with details of their income from all sources. Any tax liability over and above tax deducted at source will be collected through their self assessment record/personal tax account.
Reporting An Overdrawn Director’s Loan
There are certain tax implications for directors and limited companies when a loan account remains overdrawn for a certain period of time. Companies have to include details of directors’ loans overdrawn at the period end in their Company Tax Return. Section 455 tax at a rate of 32.5% of any loan that remains overdrawn 9 months after the end of the period end has to be paid at the 9 month date. Once the loan account is repaid or written off, the S455 tax paid is refunded, 9 months after the end of the relevant period.
If the director owes the company more than £10,000 at any time during the fiscal year, a declaration has to be made by the company of the beneficial loan interest (less any interest actually paid by the director) on form P11D. Class 1A NIC will be payable by the company at 13.8% on the beneficial loan interest amount.
The beneficial loan interest would be taken into account when calculating the individual director’s income tax liability.
If the loan is ‘written off’ or ‘released’ by the company, then this is treated as a distribution in the hands of the director so would be taxed at the dividend rate.