You may recall that in my last article (March issue), I covered, in brief, the structures of limited companies.
To recap, a company is run by its directors, and in small companies these are often also the shareholders. The ownership of the company is in the hands of its shareholders. There may be different classes of shares with different rights which will dictate shareholders’ entitlement to (amongst others) dividends, voting, and the distribution of the assets on a winding up.
Before I get onto the individual’s interaction with the company, I will touch briefly on corporation tax itself. Corporation tax is charged on the profits of the company and the rules governing the expenses that can be deducted from income to obtain tax relief pretty much follow those for partnerships, in that they must be incurred wholly and exclusively for the purposes of the trade.
In calculating the profits assessable to corporation tax, capital allowances on assets are also deducted. The small companies’ rate of corporation tax is currently 21% on the first £300,000 of profits and the full rate is currently 28%, (although these might change following the Budget on 22nd April).
When the legislation introducing the small companies’ rate first came into force, individuals split companies to try and take advantage of the lower rate of corporation tax. HM Revenue & Customs (HMRC) did not approve and these days for companies that are associated, i.e. under common control, the small companies limit is split between them.
The operation of the rules can sometimes be complex and, if in doubt, it is worth taking advice on whether or not companies are likely to be associated for corporation tax purposes.
Remuneration and pensions
Individual directors can pay themselves a salary, much the same as any employee, and these payments are subject to PAYE and national insurance contributions in the usual way. The company obtains a corporation tax deduction for such payments, unlike a partnership where the partners’ individual profit shares are subject to tax.
Self-employed individuals are able to make payments into their pension schemes, and provided they are within the allowed limits, will receive tax relief. Similarly, a limited company can make pension contributions on behalf of its employees.
It is a generally accepted by HMRC that, provided an individual is paid the market rate for his or her duties and responsibilities, remuneration can be split according to the preference of the individual. For example, if a market rate package is £60,000, this could comprise a £10,000 salary and a £50,000 pension contribution.
This may seem like a strange choice, but it should be borne in mind that if you are incorporating a veterinary practice, there is likely to be a significant level of goodwill. This is because there is an accepted market for goodwill of veterinary practices and there are a number of valuation methodologies that can be agreed with HMRC.
Typically, the company will purchase the goodwill from the individual, leaving the money outstanding to the individual as a loan to be repaid as and when funds permit. The individual will be taxed on the disposal of the goodwill so the loan repayment is tax free when it is paid out of the company. A combination of remuneration, pensions and loan repayments could be used to make up the income requirements of the individual.
There are technically no restrictions on the amount of pension contributions paid by the company that can qualify for corporation tax relief each year (although HMRC may query payments that appear “uncommercial” in relation to the duties undertaken). However, if payments by the company and/or the individual exceed the annual limit (£245,000 for 2009-10) a penalty will be incurred.
In the case of a contribution paid by an individual, tax relief is limited to the lower of £245,000 or 100% of earned income. A quirk in the operation of pension input periods may in certain circumstances allow contributions in excess of the annual limit within one tax year; however, no additional tax relief is available to the individual for contributions in excess of the applicable limit each year.
Historically, people investing in a limited company have expected to be rewarded for the risk they have taken, as the money invested in shares is unsecured: a dividend from the company is the usual reward for taking this risk.
In small companies, individuals would manage their personal income by using a combination of the extraction routes available to them.
Some might choose to pay a small salary which just exceeds the national insurance contributions limit for the second state pension, as this will enable them to have the appropriate pension credits, and they will be taxed on a salary of just under £14,000. The balance could then be paid as dividends.
It is worth noting that dividends are treated as an appropriation of the taxed profit and are, therefore, not a deduction for corporation tax purposes. The dividend is paid by the company without deduction of tax but, in the individual’s hands, the net dividend received is treated as being 90% of the gross and carries a 10% tax credit. Where the gross dividend falls within the individual’s basic rate band, no further tax is payable but, for a higher rate taxpayer, additional tax will be due, resulting in a charge of 25% of the net dividend received.
It is important to bear in mind that, if you do not draw a salary but you wish to retain a personal pension and make individual contributions rather than the company paying these, dividends do not count as earned income, so your pension contributions would be restricted to the limits for stakeholder pensions, currently £3,600 a year.
The level of dividends that can be paid is determined by the available profits within the company. It is illegal to pay a dividend in excess of the retained profits under S.830 of the Companies Act 2006 and any such illegal dividend would need to be repaid.
Having decided the level of cash flow and the level of dividends that can be safely paid out, the payment should follow the ownership of the shares. If there are different classes of shares, then each member of each class should have the same dividend entitlement, proportionate to their shareholding.
It is possible to create some flexibility within this by using dividend waivers. However, HMRC could challenge them if they are interpreted as “income shifting” between individuals – resulting in the tax liability falling back on the individual who made the waiver. Dividend waivers can give rise to a number of other tax issues and further advice should always be sought where these are contemplated.
In my last article, I mentioned that it was important to consider which assets are to become part of the limited company and which should not. The impact of inheritance tax must also be considered.
For the year 2009-10, inheritance tax does not bite until the value of the estate of the deceased exceeds £325,000, but after that the rate is 40%. In the ordinary course of events, a trading company would qualify for 100% business property relief, but property, land and buildings will not benefit from this relief if they are owned outside the limited company. In particular, if the property is let to the limited company, at best it will only qualify for 50% business property relief. The ownership of the property is also important for capital gains tax.
Entrepreneurs’ relief is available to individuals disposing of trading businesses where certain conditions are met and can reduce the tax charge to an effective rate of 10% on the first £1million of qualifying capital gains. £1 million is the lifetime limit so previous disposals (since 6th April 2008) may need to be taken into account. Property rented to a limited company at a full market rate will not qualify for entrepreneurs’ relief, so will be subject to the full 18% rate of capital gains tax.
Where the property is owned by the company, any profit realised on its sale will first be taxed in the company at the applicable corporation tax rates. Therefore, unless the company is wound up or the individual disposes of his or her shares to obtain entrepreneurs’ relief, the usual taxes will be charged on the individual in withdrawing the proceeds from the company.
Therefore, future plans for surgery or property owned for veterinary assistants need to be considered quite carefully at incorporation, as the effects can be far reaching.
As you can see, this is a complex area and it is important to give it proper consideration. There can be significant advantages in using a limited company, particularly if you are able to value goodwill on incorporation.
If, however, you are a higher rate taxpayer taking out the maximum level of dividends and the small companies rate of corporation tax creeps up to 22% for 2010-11 as expected, any savings arising from incorporation are likely to be eaten up by the costs of dealing with the complexities of filing more structured accounts, the returns and the other administration required by the legislation affecting limited companies.
- Please note that individuals should take their own professional advice before making any decisions.