My Business is my Pension – The Business Opportunity
There are 1.5m small businesses in the UK, according to the Federation of Small Businesses (2014).
This case study brings these together and highlights financial planning opportunities.
A Mr Sinclair (age 57) owns and operates a software development business. The business generated £300,000 of surplus capital that is not required to run the business day-to-day. Not happy with the investment return currently available, Mr Sinclair has decided to seek advice to help maximise his return on the surplus capital.
When asked, many business owners say that their business is their pension. It may be that the business has a sale value and the business owner intends to retire on the proceeds. Fine, if there’s a willing buyer at the appropriate time but, if not, relying on the proceeds of a sale of a business alone could scupper even the best laid retirement plans.
Using a business as a pension lacks flexibility. Instead business owners should consider moving money out of their business in a planned, tax efficient manner so that the maximum profit can be extracted and used to provide a more secure financial future.
At a meeting with his accountant it is established that, other than the £300,000, Mr Sinclair’s business has few other assets. This means that as more than 20 per cent of his business assets are deemed as ‘non-trading’ he is in danger of losing his entitlement to entrepreneurs relief.
The recommendation from his accountant is that he extracts a substantial portion of the surplus capital from his business.
Taking an income
When an owner extracts money from a business this sum is normally subject to Corporation Tax, Income Tax and National Insurance (NI).
Many small business owners decide to take a salary of around £7,000 and any remaining profit as dividends. This is because the salary has to be between the Lower Earnings Limit and the Primary Threshold for NI to ensure the individual is entitled to state benefits but it also means no National Insurance is payable – providing a benefit at no cost.
As the rate of Income Tax on dividends is lower than the rate applied to a salary, and basic rate tax credit also applies, an individual can receive up to £41,865 before any further tax is payable. However, if you go above this amount, Higher Rate Tax will be due on the portion of the dividend above the Basic Rate Tax band.
|Method of extraction||Value of £300,000 after tax:|
|All as salary||£150,872|
|All as dividend||£181,336|
|£7,000 as salary & dividend||£181,122|
So, of the two methods of providing ‘cash in the bank’ today, it is very clear why taking a dividend rather than a salary is often the preferred option of business owners.
However, if the money being extracted from the business is not required immediately this can have a bearing on the method chosen to acquire the funds.
Making pension contributions
As pension contributions are free of all taxes and NI, and don’t have to pass through any of the HMRC ‘tax walls’ that apply to salary and dividends, making pension contributions to extract money from a business for future use can often make good sense.
Of course owners must remember to leave enough money in the bank to cover day-to-day business expenses, as pension savings can normally only be accessed after age 55.
However there are two restrictions Mr Sinclair should be aware of when thinking about making pension contributions – namely the maximum contribution for tax relief and the annual allowance.
As Mr Sinclair is the business owner he can make an employer contribution to his own pension and this is not restricted to relevant earnings.
Instead Mr Sinclair must make sure his contribution is ’wholly and exclusively for the purposes of trade’. While it is generally acceptable for a business owner to remunerate themselves via a pension, it is always worth checking this with an accountant.
The second restriction relates to the annual allowance which broadly restricts tax relief on pension contributions above £40,000. Historically, this was ignored in the year of retirement so a business owner could fund their pension with the proceeds of selling the business.
However from the 6th April 2011 this is no longer the case, as such, early planning is essential. To help in these situations, carry forward was introduced. This allows unused annual allowance to be carried forward from the previous three years to the current year. To qualify for carry forward Mr Sinclair must have been a member of a pension scheme in those years. This could allow Mr Sinclair to make a total contribution of £190,000 [3 x £50,000 + £40,000]*.
As this figure is less than the £300,000 capital available, Mr Sinclair can also look to use the following year’s annual allowance in the current tax year. This will allow a further £40,000 of pension contributions bringing the total to £230,000. Additionally, this could be repeated in the new tax year to utilise the 2016/17 annual allowance which would mean a total of £270,000 invested in pension contributions by the end of April 2015.
This would leave £30,000 of the original capital which can then either be invested within the company or extracted.
As Mr Sinclair is over the age of 55, under the new pension rules, the full £270,000 of pension contributions could be exacted to provide £192,732 of net return, based on the 2015/16 rates. Naturally, tax rules and rates could be different in the future when Mr Sinclair takes his pension and it may be more appropriate to spread the return over several tax years. This could allow more of the withdrawal to be taxed at lower rates giving Mr Sinclair a higher net return.
On this basis, should Mr Sinclair wish to use the proceeds of his profitable year to put money aside for his future, a pension could prove a very tax efficient way of doing this.
The original version of this article was featured in Money Marketing January 2015.
*Annual allowance lowered from £50,000 to £40,000 for 2014/15 tax year
Source: Darren McAinsh – Prudential