Income Strategies for Small Business Owners
In this article I outline some of the factors an adviser, whether a financial adviser, an accountant, or a tax planner, should consider when looking at income strategies for a small business owner. You should note the intention is merely to show you some of the areas you should consider when reviewing such strategies. There is no one right answer and you need to look at each client’s situation case by case.
The figures used are based on tax rates and rules applying in 2015/16. If you are reading this article in a later tax year please bear in mind these rates may no longer apply (and some of the concepts and conclusions may be different).
There are two quite recent additions to our tax law which I believe advisers should keep in the back of their minds at all times when looking at income strategies:
- Employment Allowance
- Transferable Marriage Allowance
The Employment Allowance is not technically a saving for the individual. It is a saving for the employer. It means the employer can claim a discount of up to £2,000 on Class 1 National Insurance. Notice my use of the word “claim” though. This is extremely important. Unlike some other allowances it will not happen automatically. The employer has to claim it or lose it. I don’t have any statistics for how many businesses are not claiming their Employment Allowance, but I suspect it is a significant number. The good news is if your client has forgotten to claim there is a 4 year window to backdate the claim.
In the case of a business owner, the fact that it is the company rather than the individual that gets the £2,000 National Insurance discount is irrelevant. The owner is looking for the most tax efficient method of extracting money from the business; the more it costs the business the less net pay will be left for the owner.
When looking at an income strategy for the owner of a small business it may make sense to ensure the total of the salaries of all employees, including the owner, produces employer’s Class 1 National Insurance of exactly £2,000. Note I have said “may”, though. In many cases this will not be the most tax efficient strategy.
If there is only one employee, the owner of the business, to make full use of the Employment Allowance you would set the annual salary at £22,605. The calculations for this are as follows. The first £8,112 is not subject to National Insurance. Anything above that is subject to employers Class 1 National Insurance at 13.8%. £14,493 times 13.8% is £2,000. If, therefore, the salary is £22,605 (£8,112 plus £14,493) the employer’s Class 1 liability will be £2,000. As that is exactly the amount of the Employment Allowance this means no employer’s Class 1 National Insurance will need to be paid.
However, this may not actually be the best strategy. There will also be employee’s Class 1 National Insurance liability, and the allowance only applies to the employer’s element of National Insurance.
You will therefore often find it makes more sense to pay a salary up to the personal allowance of £10,600 rather than the much higher figure of £22,605. Paying salary up to the personal allowance is a strategy that has been used for many years, but advisers should now take account of the Employment Allowance before deciding whether this is the best strategy for any particular case.
Where there are two employees, and both have the same salary, the “Employment Allowance Efficient” salary for each of them will be £15,358. In the case of six employees it will be £10,527 – very close to the personal allowance. In the latter case, an “Employment Allowance Efficient” salary of £10,527 for each of the six directors would very often be the optimal salary, with the remainder of the required income being taken as dividend. Obviously the calculations here will vary case by case, as the directors may well not all be entitled to the same income from the business, and there may also be other employees.
Transferable Marriage Allowance
There is a Transferable Marriage Allowance of £1,060. This may not seem much, but it is very worthwhile taking advantage of this where a client’s circumstances fit.
Bear in mind this allowance can be transferred either way. The most obvious way of using it is to transfer some of the personal allowance of a non-working spouse to a working spouse. This is not the only circumstance, however, in which it could be a useful strategy. For example, your client may be a business owner with total control on how much income he takes from the business, and his wife may work full time for another company. It may make sense to apply for a transfer of £1,060 personal allowance from the client to his wife and then change the balance of salary/dividend your client receives from his company.
The Transferable Marriage Allowance is only available where the spouse receiving the allowance is not a higher rate or additional rate taxpayer. You may find, though, that many of your clients would qualify, particularly where you are looking to transfer the benefit from a business owning client to the spouse.
You should note that the Transferable Marriage Allowance is not paid automatically, and must be claimed by the spouse intending to transfer part of their allowance. It would usually make sense to apply early on in the year rather than waiting until the annual return is submitted, as this should then allow your client or their spouse to receive the benefit through PAYE.
As I have mentioned above, restricting salary to the personal allowance (or possibly an inflated personal allowance after transfer of part of a spouse’s allowance) and paying the rest of the required income through dividends has always been a good strategy for many clients, and remains so.
If your client runs a business from home, you may consider suggesting the business pay rent for the use of the home. When doing so, though, make sure the Revenue cannot argue a room in the house, or even part of a room, is reserved exclusively for business. If they can argue this, it will potentially cause the client capital gains tax problems when the house is eventually sold. Usually this argument can be countered quite simply – for example by putting a television in a room used as an office, showing it is not exclusively used as an office. To be on the safe side, take a photo of the room with the non-business items in it, and then store that photo safely so it is available if there is a later challenge.
Has your client lent his company any money? If so, make sure he claims interest on the loan, ideally at as high a rate as he can reasonably claim is commercial. This is more tax efficient than salary unless the salary is already £8,112 or less, as there is no National Insurance on it. When reviewing the salary/dividend balance, you should consider the interest as appearing on the salary side of the equation as it will still increase the total income on which tax is paid, whereas for a basic rate taxpayer the dividend will not.
Finally, consider whether there is any merit in your client receiving more remuneration via a company contribution into a pension. If the client is under 55 and needs the income, this will not apply. However, if the client is 55 or over you may wish to consider a strategy of passing some income from the company into the pension, and the client then immediately taking that income out as a combination of pension commencement lump sum and taxed income, or even entirely as pension commencement lump sum if it seems appropriate to defer some tax to later years. When considering this strategy, though, be aware you may be limiting the annual amounts the client can invest in pensions and make sure the client is also fully aware of this.