How should you extract profits from your business?

In previous blogs, we’ve been tackling some of the commonly asked questions that come with the lifecycle of starting, running and growing a business. The third part of our series considers the business owner and how profits made by the business can be extracted in the most tax-efficient way

For a sole trader, the position is relatively straightforward

The business and the individual are not separate legal entities, so you do not technically “extract” profits from the business in the same way as a company director or shareholder.

A sole trader is not directly employed by the business and won’t receive a salary in the traditional sense. Instead, sole traders pay themselves by withdrawing money from the business account.

When it comes to tax, however, sole traders are generally taxed on all profits made by the business, regardless of whether or not all of those profits are withdrawn.

A limited company is different – there are more options and more complexity

The company is a separate legal entity so there are different extraction routes to consider which commonly include payment by way of salary, dividends, employer pension contributions or a combination of these options.

Salary is paid through PAYE and is generally an allowable business expense for Corporation Tax purposes, subject to the normal rules.

Dividends are paid to shareholders from available post-corporation tax profits and have their own tax treatment. Employer pension contributions can also be used as part of a director's wider remuneration and retirement planning, subject to the relevant rules and limits.

It is generally optimal from a tax perspective for company owners to receive a modest salary and larger dividends but whether or not this is the best option is dependent on individual circumstances.

The key difference between a company and sole trader is that a company owner is not subject to tax in a personal capacity until they extract funds from the company. The flexibility over when and how profits are extracted can make a company attractive – but it does not automatically make it more tax efficient overall.

It’s important to look at the whole picture

A business owner might be told that they can save tax by taking a combination of salary and dividends, or by making pension contributions through their company. These can all be useful strategies, but the starting question should still be - is a limited company the right structure for my business?

There are several reasons why a company might be the right structure, particularly given the flexibility a company can provide when it comes to profit extraction. However, as covered in part one of our series, there are positives and negatives of each structure option. The optimum position really depends on your objectives.

Tax planning needs regular reviews

Tax legislation and rates change and a structure that was highly attractive when a business was first established may not remain the best option indefinitely.

That is why tax planning should be an ongoing conversation rather than a one-off decision made when the business is first established. Plus, the way the business is structured can have implications for the options available to you when you exit but we will cover more of that in the final blog of the series.

Want to talk more about the best way to make the most of your profits as a sole trader or with a limited company? Contact Monahans’ tax team to see how we can help.