How to extract profit from a business
Despite the economic challenges of 2022 – including runaway inflation, rising interest rates and a jobs market where the best talent is snapped up in an instant – many businesses are starting to boom again.
These businesses may want to cash in on their success by extracting some profits. But how do you effectively judge how much you can withdraw from your business without causing future cash-flow problems? And what are the tax implications when a business takes cash out through dividends, salary or by paying into a pension?
Cash flow modelling
How much you decide to withdraw depends on your plans for the future – both personal and for the business – and how much risk you’re willing to take. It’s both an art and a science.
Cash-flow modelling can help many business owners to get an idea of what they’re likely to spend over a certain number of years. You can then work out what won’t be needed and how much you can distribute.
Then there’s what you might call the art side. These are the intangibles of what you want to use your business for. Is it a lifestyle business that you run to fund yourself and your family? Or do you want to grow and develop it into something big?
One common mistake is to overestimate how much cash your business will need and leave it in company accounts, rather than rewarding yourself for years of hard work. This is where modelling can help to work out how much your business is likely to require – and what you need to achieve your personal financial goals.
What are the risks of withdrawing too much?
It’s also possible to take too much cash from your business, leaving it vulnerable to unexpected events, such as a sharp economic downturn or the departure of a long-term client.
You need to have a plan, look at the future and create a holding of cash for emergencies. It’s the same as the principles of financial planning that you would apply to an individual.
The final decision on how much to withdraw will often come down to the personality of the business owner and its directors. Some will want to reinvest profits into the business to keep it growing, even during a boom. Others will be more conservative and bank profits when they become available.
How do you increase what you earn from a company?
There are three main options if you want to extract profits from your company. They are:
- Take more salary
- Pay extra pension contributions
- Pay a dividend
An entrepreneur should consider carefully their remuneration structure and many business owners will use a combination of salary and dividends to reduce/remove their national insurance contributions. This is a complex area but one where good financial advice can be invaluable.
What if you want to take a lump sum out of your business?
For most business owners, paying a small salary and dividend is likely to be the most tax-efficient option, although this isn’t the case for everyone.
One tip from Simon Martin, Consultant at Technical Connection, St. James’s Place’s technical support partner is to include family members who work for the business to maximise the tax efficiencies available, particularly the tax relief available on pension payments. Pension allowances can often be overlooked and remain unused.
Another tax efficient way to extract profit from your business is to pay into a pension, it’s also an essential part of planning for the future. When you pay into a pension you can claim the tax relief on contributions at the end of the tax year.
If your business has had a bumper year, you may also be able to take advantage of carry-forward rules and pay more than the annual allowance (currently 100% of your earnings up to £40,000) into your pension. This allows you to use any unused allowance from the previous three years in the current year.
Here are the key tax changes for entrepreneurs to be aware of in the 2022/23 tax year:
Income Tax: The personal allowance remains at £12,570, while the higher-rate threshold – the point at which you’ll start to pay 40% Income Tax – stays at £37,701 of taxable income or £50,271 of gross income.
National Insurance: Employers’ National Insurance contributions have increased by 1.25 percentage points. From July, the primary threshold for employee National Insurance contributions increases to £12,570, in line with the Income Tax personal allowance.
Dividends: The Dividend Tax rate increased by 1.25 percentage points in April. The dividend allowance is unchanged at £2,000.
Personal pensions: Most people can get relief on pension contributions of up to £40,000 or 100% of their earnings if lower a year. The lifetime limit of £1,073,100 is in place until 2026.
Capital Gains Tax: The Capital Gains Tax annual exempt amount for individuals will remain at £12,300 until 2026.
Inheritance Tax: The Inheritance Tax nil-rate band for 2022/23 remains at £325,000 and will be frozen until 2026. The residence nil-rate band stays at £175,000.
Finding the most tax-efficient solution needs to be taken on a case-by-case basis. Everyone’s situation will be different and business ambitions will also vary. It’s always best to take advice on extracting profits from your business
Tax rates apply to England only
The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.