Pension Planning for business owners
Business owners are having to rethink the best way to extract profits from their company and pensions are most definitely in their thoughts. Changes to how dividends will be taxed from April could see a reduction in the spendable income they currently receive. A pension contribution could be the best way of cutting their tax bill, while still receiving the same level of benefit. And the best time to start extracting surplus profits could be right now.
Paying themselves dividends is still a better option than the equivalent amount of salary. But the gap is narrowing for high earning directors. A director receiving a net dividend of £100,000 will be £6,300 worse off under the new rules.
From April everyone will get a £5,000 tax free dividend allowance. Dividends in excess of the allowance will be taxable at 7.5%, 32.5% or 38.1%. Currently business owners only pay tax on dividends when they take income above the basic rate tax band. That’s because the notional 10% tax credit, which will be abolished from April, satisfies the liability for basic rate tax payers. So from April business owners could be paying a higher rate of tax on a larger slice of their income.
Tax efficient extraction
But a pension contribution remains the most tax efficient way of extracting profits from a business. An employer pension contribution means there’s no employer or employee NI liability – just like dividends. But it’s usually an allowable deduction for corporation tax – like salary. And of course, under the new pension freedoms, those directors who are over 55 will be able to access it as easily as salary or dividend. With 25% of the pension fund available tax free, it can be very tax efficient – especially if the income from the balance can be taken within the basic rate.
The table below compares the net benefit ultimately derived from £40,000 of gross profits to a higher rate taxpaying shareholding director after April.
|Pension income taxed @ 20% 1||Pension income taxed @ 40% 1|
|Corporation tax @ 20%||£0||£8,000||£0||£0|
|Employer NI 2||£4,850||£0||£0||£0|
|Director’s NI 2||(£703)||£0||£0||£0|
|Income Tax||(£14,060)||(£8,775) 3||(£6,000)||(£12,000)|
|Net benefit to director||£20,387||£23,225 3||£34,000||£28,000|
1 Assumes pension benefits are taken within the Lifetime Allowance.
2 Assumes NI rates for 2015/16 (13.8% employer, 2% employee).
3 Assumes full £5,000 annual dividend allowance is available.
The financial dangers of hoarding cash
There may also be a spin off benefit of paying surplus profits to a pension instead of capitalising it.
Shares in unquoted trading companies normally attract IHT business property relief (BPR). But cash built up in the company bank account or investments held within the company could be regarded as an ‘excepted asset’ and not qualify for BPR.
Paying into their pension could help ease this. There is typically no IHT payable on pension death benefits. Extracting the cash from the business in the form of a pension contribution could result in an immediate reduction in the business owner’s estate. And once inside a modern, flexible DC pension the wealth can be cascaded down the generations outside their estates.
Capital Gains Tax
Holding excess cash in the business could cause similar issues when shares in the company are sold. Entrepreneurs’ relief is valuable to business owners as it can reduce the rate of CGT payable on the disposal of qualifying shareholdings to just 10%. To qualify the shares must be in a trading a company.
While cash reserves are not looked at in isolation, holding substantial cash and other investments could contribute to a company losing its ‘trading’ status. And unlike BPR, entrepreneurs relief is all or nothing. If cash and investments trigger a loss in relief it affects the full value of the business disposed of; not just the non-trading assets.
This could have huge implications for business owners approaching retirement and planning to sell their business as part of their exit strategy. Extracting surplus cash through pension planning to ensure entrepreneurs’ relief is secured on sale of the business will be an important consideration. And there’s no CGT on pension assets.
There’s no reason why directors should delay extracting profits from their company until after April. In fact there are some very strong reasons for maximising contributions now.
- Business owners who take flexible drawdown income will see their annual allowance available for future pension savings cut to £10,000 (with no carry forward). So they may need to pay now and mop up any unused allowance using carry forward. But remember that dipping into pension savings by only taking tax free cash maintains the full allowance for ongoing funding.
- High earning clients who will face a reduction in their annual allowance to £10,000 from next April may want to maximise their contributions now.
- The 2015/16 PIP changes could mean that some clients have additional annual allowance available before April.
- The main rate of Corporation tax is set to fall by 1% in April. So making a contribution in the current accounting period could benefit from higher corporation tax relief.
- An announcement on the future of pension tax relief is expected in 16 March Budget and there are no guarantees that the current tax relief rules will remain the same.
Source: Standard Life