Taxation is a necessary part of any business, but nobody wants to pay more than they have to. However, many SMEs appear to be doing just that, whilst struggling to calculate their tax liability accurately. Research carried out as part of the Office for Tax Simplification (OTS) small business review found that around half of the SMEs consulted were concerned about applying tax rules incorrectly. In addition, around 20% (potentially 700,000 businesses) reported finding it difficult to calculate exactly how much tax they should pay.
1. Get your structure right
The way that a company is set up has significant implications for the amount of tax payable. Whilst many small businesses still trade as sole traders or partnerships, the majority would actually pay less tax and NI if they converted to a limited company. The key is to structure pay and dividends efficiently. As a guideline, any company with profitability in excess of £20k would justify a consideration of incorporation.
A structure involving both a limited company and an unincorporated business can be very tax efficient, especially if anticipating high growth and profitability in the future. This utilises advantageous tax rules relating to Goodwill and involves building up the unincorporated business until it has a decent value. It can then be sold to the limited company for its market value, with significant tax benefits.
2. Utilise family tax allowances
If spouses, children or other relatives aren’t using their Personal Allowance (currently £8,105), there may be legitimate ways of ensuring this is maximised. For example, children can legally work from the age of 13, which means that children and other relatives are eligible to carry out basic tasks for your business. However, these activities must be relevant and justifiable. There are also ways of splitting assets to reduce the tax rate on the income.
If you have children over 18 with skills that are useful to the business, they can either be paid as an employee or can form their own company and invoice you. For example, they may be able to help with design work, IT, website administration or creating business apps. This can also be a good way of funding university costs, rather than from your own income, taxed at up to 40%.
Paying a low salary topped up with dividends has been an effective method for remunerating business owners for many years. From 6th April 2013, the optimum salary for a director/shareholder would be £7,690 p/a. The maximum amount of dividends payable without incurring the 40% tax rate would then be £30,384. The salary should be paid as a director’s fee rather than as a wage to avoid National Minimum Wage regulations.
4. Manage your finances smartly
Lots of business owners want to pay off their mortgage. However, doing so may well mean taking dividends from their company which could get taxed at 25% or more. This poses the question: is it wise to incur a 25% cost in order to save interest which can be as low as 1.5%? It may be more tax efficient to keep funds in your company as long as possible, because if you eventually sell the company or close it down, these funds could be released to you after only 10% tax. However, it is advisable to avoid becoming an ‘investment company’ which could dilute your entitlement to Entrepreneurs’ Relief.
5. Child Benefit
Changes to Child Benefit mean that it will now have to be repaid totally if one half of a couple earns over £60k, and repaid in part if earnings exceed £50k. If both partners earn £50k or less, there would be no repayment. This means that there may be scope for you to review your earnings levels and split of earnings to make savings.
6. If you earn over £100k…
If your taxable income is between £100k and £116,210 (or from 6th April 2013 £118,880), your marginal tax rate will be 60%. It then reduces down to 40% before increasing to 50% (45% from 6th April 2013) if you earn over £150k. You could make substantial tax savings by taking steps to reduce your taxable income, most notably by making additional pension contributions.
7. Make use of tax efficient investments and payments
Pension contributions provide tax relief at your marginal tax rate so could save up to 60% in tax, subject to the annual maximum of £50k in 2012-13 and 2013-14. You can also take advantage of any unused allowance from the previous three years.
ISAs provide tax free income. The annual contribution limit is £11,280, of which £5640 can be in cash. It’s also worth considering the new Junior ISA for under 18s where £3600 can be invested.
Other tax efficient investments include Enterprise Investment Schemes (EIS), Venture Capital Trusts (VCT) and Seed EIS (which may be suitable for small business investments where your shareholding is less than 30%).
You can invest up to £200,000 in a VCT which gives you 30% tax relief on the initial investment (if you hold it for 5 years); the VCT is also free of Capital Gains Tax (CGT). After 5 years you may be able to reinvest your initial investment and obtain a further 30% tax relief.
With EIS investments you can invest up to £1m and get 30% tax relief if you hold them for 3 years. There is an added benefit for an investor who has a CGT liability – this can be deferred by investing in EIS and after three years will become exempt.
8. They get you in the end… (Or do they?)
You work hard to save tax for all these years, and then when you get old you may lose most of it paying for long term care or Inheritance Tax (IHT). However, there are ways of protecting your assets.
9. Plan to save Inheritance Tax
Ironically, HMRC save the largest tax until you’re not around to protest. However, there are many things you can do to avoid IHT. Whilst some people aren’t bothered about this form of tax because they won’t be around, it is also important to consider the IHT planning carried out by your parents. With careful planning you could increase your inheritance by 67%.
10. The next generation
If you have concerns about your children frittering away the assets you’ve worked so hard for, there are things you can do. Rather than leaving assets to them directly, they could be left in a trust. This way your children still have the same access to the assets, but if they get divorced or go bankrupt, for example, these assets won’t be lost but will still be in trust for your children’s benefit. As an added benefit, this kind of planning could also protect assets from care fees.
The four billion plus small businesses in the UK make a vital contribution to the British economy. However, with many still battling the financial pressures imposed by the recession, it is essential that business owners ensure the structure of their tax affairs is as cost effective as possible. Times are tough, so now more than ever, why pay more tax than you have to?
Carl Elsby is Managing Director of chartered accountants Elsby & Co who specialise in working with SMEs, start-ups and family businesses. For more information, visit www.elsbyandco.co.uk, call 01604 678470 or email firstname.lastname@example.org.