If you’re self-employed, your money will move in a familiar cycle: you trade, earn income, fund expenses, and pay tax on profit. There’s just you, and anything that’s left over is yours to spend.
If you own a company (and if you are the only person in your company), things get a bit more complicated. Legally, you and the company are separate entities. And to add a layer of complexity, for you there are two distinct roles: director and shareholder.
The money you make belongs to the company, rather than going into your pocket, meaning that you can’t quite spend it however you like. As a director, you may be paid a salary, which may be fairly small for tax efficiency. In this role, you’re in charge of running the company and making sure expenses are paid and operations are run. You’re also responsible for getting accounts prepared, in order to understand the amount of profit the company has and work out how much corporation tax it must pay. It’s this after-tax profit that can be distributed to shareholders. Which are – you’ve guessed it – you.
As a shareholder, you can take dividends, which only encompasses money that’s actually there for the taking: i.e. what’s available in profit. This doesn’t include the money you need to set aside for tax. As an example, if you earn £200,000 and your expenses are £100,000, you’ll have £100,000 left. However, 20% of that £100,000 is tax, so you can only really take out £80,000.
The problem here is that a casual glance at your company bank account might lead you to take the whole £100,000. Taking “unavailable” money in this way counts as a loan from the company, and opens a real can of worms. In essence, you’re treating the company’s money as your personal expenses, making yourself in debt to it.
If you’ve fallen into this trap, you’re not alone – profit and dividends can be hard to get your head around, especially if you’ve been a sole trader until recently. But to avoid this happening, it’s better to follow the correct process for accessing your money. This means declaring dividends on a quarterly basis before taking the profit, which ensures that you’re only taking what’s actually available to distribute. Here, there are inbuilt safeguards, as the system won’t allow you to declare dividends over the profit you’ve earned.
As mentioned, if you don’t have enough profits to declare dividends, and you’ve drawn out more money than you should have, you’ve essentially created a director loan, because you owe the company money. This loan has to be repaid within nine months to avoid further tax implications. If the loan still exists after this period, you’ll be subject to something called ‘Section 455 tax’ at 32.5% which is potentially repayable by HMRC depending on circumstances. Repeatedly taking director loans and not repaying them within the time frame can lead to a mounting problem, which we often see being kicked down the road year after year. Alternatively, it can be a positive tax strategy if it’s backed up with a plan.
Ultimately, being in a company reaps more tax benefits, and always has. Despite the extra admin it creates, it’s a step well worth taking, but you do need to manage your company properly, and avoid becoming overdrawn, unless you’re able to stay on top of this.
A key step you can take is to make sure your bookkeeping is up to date and accurate. Look at it on a quarterly basis, and have a chat with your accountant to understand the amount of profit available to distribute to shareholders. What bookkeeping won’t tell you is how much corporation tax you need to pay for each quarter. This is best supported by management accounts – which, at Hive, means a professional assessment of your bookkeeping, making sure it’s tidy and up to date, and considering all the other things that interact with tax. From this, we can tell you the amount of tax you’ll need to pay, and therefore the amount you can safely take out.
