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Drawing Profits From A Company – What You Need To KnowWritten on October 3, 2019 by Kirk Rice LLP

Drawing Profits From A Company – What You Need To Know

One of the most common questions we get asked is how can companies access the profits and reserves which they have built up in their business in the most tax-efficient way. In this blog, we cover some of the key aspects you need to know when drawing profits from a company, and, the options available.

Salary and Bonuses

Directors of owner-managed companies often draw low levels of salary, typically between £7,500 and £9,500 per annum. The reason for this is because a salary attracts a National Insurance levy. The National Insurance rate for employees is 12% between £8,632 and £50,024 and 2% above this figure. The Employers’ National Insurance rate is 13.8% above £8,632. This gives a combined National Insurance liability of 25.8% which is a tax you would want to avoid although the Employers’ National Insurance element is deductible for Corporation Tax purposes. For further details on National Insurance rates, see the HMRC website.

How Will Drawing a Salary Affect My Pension Contributions?

It is normally advisable to draw a minimum salary from the business so that you don’t lose any entitlement for social security benefits. You need 35 years of contribution to qualify for the maximum state pension under the new state pension scheme which came into force from 6 April 2016. We normally advise that the minimum basic salary is £8,632 to qualify for these pension entitlement requirements.

The problems with drawing a low salary are minimal. However, your level of personal pension contributions will be affected. The personal pension contribution cannot exceed an individual’s earnings in any one year. For example, if an individual makes a £10,000 gross pension contribution, you must have earned £10,000 of salary. It is worth noting that dividends, interest, and other investment income do not count as earned income when making a pension contribution. For more details on pensions, we have a whole section dedicated to this topic on our website.

Implications for Loans and Mortgages

Individuals have previously found it difficult gaining approval for a personal loan or mortgage due to low salary levels based on the drawings above. However, more lenders are now becoming aware of the situation regarding owner-managed businesses. In general, they are now more prepared to look at the overall financial status of the business when considering whether to approve the loan. If you require help in this matter please contact us.

Employment of Family Members

If your spouse or civil partner, or any other family member, has little or no income, it can be beneficial for your company to employ them for profit extraction purposes. Your appointed family member could receive between £7,500 and £9,500 per annum, incurring little or no tax liability for your company. Furthermore, the business would benefit from a 19% corporation tax saving. As previously mentioned, if the individual earns between £5,800 and £8,000, they would retain their entitlement to social security benefits without adding National Insurance costs. Please be aware though that the salary must be justifiable commercially in order to be deductible to corporation tax.

In general, the most advantageous option is to employ your spouse as a Director or Company Secretary where they can carry out relatively minimal duties to validate this as a basis for remuneration.

Is Drawing Dividends An Option?

The main advantage of drawing dividends is that National Insurance is not payable when a dividend is taken regardless of your personal income tax rate or your company corporation tax rate. We, therefore, recommend that Owner-Managers take a small salary to use up their personal allowance and withdraw the remainder of their income as dividends. 

Despite the publicity around the tax increases in 2016, which saw an increase of up by 7.5% in each tax band, the dividend savings remain substantial. This is especially the case where you can share the dividends amongst family members or your spouse. In this instance, you and your spouse can remain below the higher rate tax threshold.

Are There Any Drawbacks to Taking a Dividend?

Your company must have sufficient profits or qualifying reserves to declare the dividend. This is the case even where the company may have ample cash in the company bank account. Where that is not the case, a salary or bonus can be paid even if it means that the company declares a loss.

Dividends must be paid out in proportion to the shareholdings. This is unlikely to cause a problem where you are the only shareholder. However, it can become more complicated where there are several shareholders or where there is an outside investor. One option, to ensure that this can be carried out effectively and legitimately, is to have separate classes of shares, on which different levels of dividend can be declared.

Where you pay higher or additional rate tax on the dividends, this falls due on 31 January following the end of the tax year, in which the dividends are paid, and provides considerable time to settle your personal tax liability. That delay can help with cash flow, however, it can also catch you out if there are insufficient funds to pay off the tax bill at that time. See the HMRC website for further information on dividends.

Are Benefits In Kind An Option?

It generally doesn’t make financial sense to receive fringe benefits from the company, such as a company car or buying a property for personal use. Although there is no employee national insurance due on these benefits, the company must pay National Insurance on them at 13.8%. Therefore, it is generally preferable to take a dividend and pay for the benefit personally.

Working out the most beneficial option is not always a straightforward option. This is because it is sometimes worthwhile taking certain types of benefits as they attract special tax rules such as company cars, a loan for your company or occupying accommodation provided by the business.   

Being provided with the benefit may be preferable where it is exempt from tax or has a low tax charge. One example of an exemption is mobile phones which include smartphones. Electric cars have a low beneficial tax rate from April 2020 as do some low emission vehicles. Be warned: company tax rules are constantly changing, particularly in relation to cars. Therefore we recommend you speak to us first, as we can help you to work out the most tax efficient option for you.

With a high-value item such as property, you can declare a large dividend to cover the purchase but this is likely to push you well into the higher rate tax band. If the company purchases the property for your use, the tax benefit will be substantially lower. The benefit will, of course, continue to be charged each year but it may be worthwhile if your income remains below the 45% additional rate of income tax.

Pension Contributions

Pension contributions are generally highly tax efficient and can be made into any registered pension scheme. These contributions can be deducted from the company’s taxable profits, on the proviso that they are made before the end of the financial year. A pension is not treated as a benefit, therefore, there is no tax or national insurance liability.

When the time comes to withdraw the benefits on retirement, the funds are free from capital gains tax, and, a quarter of the fund can be withdrawn as a tax-free lump sum. The balance will be subject to Income tax but not National Insurance. There are two clear disadvantages with this. Firstly, you will not have immediate access to the funds as they are locked until the age of 55. This is due to increase to 57 in 2028. Therefore pension contributions are more appropriate for those who have sufficient income in salary, bonuses, and dividends to cover immediate expenses. 

Secondly, pension contributions are restricted to an annual limit of £40,000, with further restrictions for those earning over £150,000. 

You can also pay your spouse a pension contribution although, be aware that this must also be on a commercial basis to be allowable as a deduction for corporation tax purposes. We would recommend restricting this contribution to around £10,000, unless they are fully employed within the business.

Although you will not have access to the pension funds, it may be possible in some circumstances for the pension to lend money back to the company or to purchase a property for company use.

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Retaining Profits Within the Company

You might decide to leave the profits within the company if you do not wish to be liable for tax charges incurred once money is withdrawn. Listed below are several options:

  • Investments. One option would be to invest these funds as you would do on a personal basis. For example, you might decide to buy shares or an investment property. 
  • Use the surplus funds level out salaries and dividends, in case the company has a poor-performing year.
  • Leave the funds within the company until your retirement. This possibly allows you to withdraw funds at a similar level in retirement as you would do, before retirement. This option allows you to manage the taxable profits over a longer timescale. It is less tax efficient than paying money into a pension scheme. However, it does give greater flexibility.
  • Cease trading and wind up the company. This allows you to withdraw the funds as a capital gain. If your reserves are over £25,000, a formal liquidator must be appointed to undertake this action. The advantage of ceasing trading is that it is often less expensive than withdrawing the money as salary and dividends: any reserves left in the company are subject to the entrepreneur’s rate of Capital Gains Tax at 10%. However, you need to take care with this approach. If there are significant investments within the company, it may not be classed as a Trading Company, but as an Investment Company, and, therefore will not qualify for the Entrepreneur’s rate of 10% but will be subject to the standard rate of 20%.
  • Retire abroad with the possibility of withdrawing the accumulating funds tax-free. It would be necessary to leave the country for more than 5 years although this shouldn’t be a problem if you’re retiring and, provided the plans were definite, there is no reason the funds could not be withdrawn sooner after leaving the UK and used to fund your retirement plans. You should, of course, consider the tax position of the country into which you are setting as they may have different capital gains’ rules to the UK.

Sell the Company

In the longer term, you may be in a position to sell your company especially if it is growing. If the business is an owner-managed operation, you could leave any excess profits in the company in the final years as discussed earlier and then sell the company on. You can retain the excess profits at a rate of 10%. It will normally be beneficial for you to sell the company shares rather than the company sell it’s business and assets. If the company sells it’s business and assets you’ll face the problems of extracting the sales proceeds from the company which could mean a double tax charge. However, the most important consideration here is to make sure that the company qualifies for entrepreneur’s relief of 10%.

The company must be a legitimately trading company and this may not be the case if more than 20% of the income or assets are non-trading.

When considering how to withdraw profits from your company the most important factor is to ensure that the company qualifies for Entrepreneur’s relief of 10%. Bear in mind the longer term financial and tax position of your company. Otherwise, it may result in you potentially losing some or all of your personal allowance or incurring unnecessary child benefit tax charges.

Some clever schemes have been featured in the Press which allow you to withdraw profits from the company at a minimal tax cost. Be warned that HMRC is clamping down on these schemes. One such example is Employee Benefit Trusts which were widely marketed as a way for high earners to reduce their tax liability. They involved directors and employees taking loans rather than remuneration or deferring income until the tax liability was deemed to be more advantageous. Not surprisingly, these schemes are no longer effective.

As the Owner-Manager of your company, you are in the best possible position to decide how you receive your income and what form it takes. When considering your position, please get in touch as we can help you make the best decision for you and your company. For further details on this topic please see our guide on Drawing Profits from a Company.

As the owner manager of your company, you are in the best possible position to decide how you receive your income and what form it takes.

Any reader interested in getting some help with deciding whether you should register your business for VAT, should email info@kirkrice.co.uk to arrange a call with one of our financial planners.

Keep up to date with business accounting and tax changes.

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Please note: answers are given for general guidance only and specific advice should be taken before acting on any of the suggestions made.