Either way, we always remember that the key factor is to generate wealth and be able to access it as easily and as tax efficiently as possible. We keep this in the forefront of our mind when advising businesses owners, so that cash is not stockpiled in the wrong place whilst ensuring that clients have access to the funds in their business when they need it. Ideally, this is all done, without triggering unnecessary tax bills. But, to take money out of a profitable business, there are some fundamental principles to remember.

Principally, the business should have a separate bank account to the business owner and the money in this account isn’t yours until you ‘pay it’ to yourself. Business funds should be kept separate from personal finances and treated like they are someone else’s.

How the business was initially set up and funded will also have an impact on the remuneration plan we create for a business owner. At Cypher we generally deal with business owners of private limited companies. As a separate legal entity, limited companies  not only protect their owners from certain liabilities, but stand to be more tax efficient than sole traders.

1: Director’s Loans v Share Capital

For start-up limited companies, the distinction between a director’s loan and share capital is something we spend quite a lot of time discussing. This is a concept that trips up so many new business owners so it is vital they get a handle on how their director’s loan works and why it’s so important.

A typical scenario might be that to set up a business and fund it for the first five to six months, a director or owner transfers a payment of around £15,000, into the company bank account. Generally, we would advise that they DON’T put this in as share capital (i.e. create 15,000 £1 shares), when they set the company up.

If a business owner invests their £15,000 in this way, this money belongs to the business; it is sunk, dead, and is not coming back to them until the company is closed down. Instead, what they should do is create a single £1 share and invest the remaining £14,999 as a director’s loan – a loan from them to the company. As and when funds are available, this loan can then be repaid, tax free, to the business owner.

If, once the business is profitable, they want to take funds out of their company, they have the option of taking dividends (the first £2k of which is tax free, the rest taxed at either 7.5% or more) or repaying the director’s loan.

Generally, the most tax efficient strategy comes from a mix of dividends and directors loan repayments. We do advise a note of caution here, as this is an area that can cause difficulty for some business owners.

If a business owner provides a start-up loan and then begins to draw on these funds, monthly as part of their remuneration package this is fine in itself, but, if the company stops making a profit,  and the owner/director continues to take this same amount then the directors loan account could end up overdrawn (i.e. the business is now loaning money to the director!).  This could result in a 32.5% Corporation Tax charge if it’s not managed correctly, so it’s really important to talk to your accountant about your director’s loan balance regularly.

2. Directors salaries

Business owners running a limited company must remember that the revenue and profits they generate are NOT their money, it is the company’s money until they pay themselves a salary or take funds out as dividends.

If a business owner intends to pay themselves or any other employees more than £113 a week, they should first register for a payroll scheme with HMRC. If you use Xero to run your business accounts you can use its inbuilt payroll module to create the payslips and file the monthly reports with HMRC.

If you would like advice on setting up a payroll scheme or with running your ongoing payroll then get in touch with our experts today

Typically, most directors’ start on a salary of around £9,500 a year, which we recommend businesses put through as payroll. This amount is below the threshold for personal tax, and National Insurance Contributions (NIC). Business owners avoid paying Income Tax and NIC, but they still qualify for the State Pension and benefit entitlements because they earn above the Lower Earnings Limit of £6,204/year. The company then saves 19% Corporation Tax; this is the same for every director that contributes to the business.

3. Dividends

After wages or loan capital, assuming the business is profitable, further funds can be taken out as dividends. Dividends represent the distribution of corporate profits to shareholders, based on the number of shares each holds in the company. This is an important point to note, as any dividends paid out need to be in proportion to share ownership. If it is a 50/50 split, then one director can’t be paid 100% of the dividends.

It is worth knowing that the first £2,000 taken out as dividends is tax free; the balance is taxed at the dividend version of your marginal rate which is 7.5% or 27.5% depending on your level of taxation. If a business director decides to take the minimum allowance as a salary and instead take the majority of their funds out of the business as dividends, then to understand the level of dividends a company can yield, first we have to understand what profit the business is expected to make over the 12 months of its financial year and how this will affect cash flow.

Remuneration planning

To help business owners plan the remuneration they can or need to take out of a business, we spend a lot of time with start-ups building them a basic remuneration plan. Often a new business owner will have some funds to survive on for the first five to six months, but we also advise them to still take a salary even if it is at the lowest rate. This is sensible for tax planning.

Then in month nine of a business’s financial year, we offer a pre year-end review, which is a service we provide for all clients. This means that clients get tax advice before the year end, rather than after year end. You can do little to affect it in month 13 because it has already happened.

By month nine we can forecast a more robust remuneration plan, identifying the real levels of profit a business is likely to make. We know we are taking out £9,500 for salary, we need to keep around 20% back for corporation tax, which leaves a dividend of ‘x’ that a business owner can then take out of the business.

Having a business plan and a remuneration plan enables a business owner, particularly a start-up, to have confidence that they can survive the first year and understand the levels of income they can expect. Tying all their funds up in their business may not be feasible with other household bills to pay.

Step 1 Business Structure

The first step for any business owner is to understand what structure their new business should have in order for it to be run most effectively. Getting this right in the beginning is important because you don’t want to find that seven months down the line, when the business is flying, that you have to change structure. Generally, we do this by fast-forwarding 12-18 months; we look at the potential of the business, try to understand what it might look like in the future and create the right structure to support that business. For the majority of UK businesses there are four options; two unincorporated and two that are incorporated with Companies House.

Sole trader 

An unincorporated, sole trade business is the simplest setup. You need to prepare a simple profit and loss account and file an annual tax return with HMRC to report your profit, but that is it. But remember, as a sole trader, you are taxed on this profit, whether you take the funds out of the bank or not.

Partnership 

A partnership is exactly the same as a sole-trader, except there are two or more people of equal standing in the business. You have to file a partnership tax return and then personal tax returns each year but your business remains unincorporated.

Limited Liability Partnerships (LLP)

LLPs offer you the liability protection that a company does but the tax position of a partnership. The only real benefit of an LLP type structure is that if you have a business that changes owners fairly regularly, like a professional services partnership, which has partners retiring, new partners coming in, you use the LLP, which is easier than a private limited company to do that.

Private Limited Companies 

Within our client base, Cypher supports around 96% private Limited Companies as this is the route that is most suitable for our clients. Typically, assuming you will make a profit of more than £45-50,000 a year, then this is the most tax effective way to set up a new company.

The largest benefit for doing this is liability. As a separate legal entity, limited companies  not only protect their owners from certain liabilities, but stand to be more tax efficient than sole traders. Being incorporated protects the business owner from being sued and losing their personal wealth, possessions or even their house. Assuming you don’t do anything fraudulent, as a business owner you are only liable for the amount of share capital you put in at the start or any outstanding funds, like bank loans that you may have personally guaranteed.

The second benefit is the tax efficiencies. As a sole trader, you are taxed on all of your profits, whether you take funds from the business or not. As a limited company, companies pay Corporation Tax on their profits of a flat rate of 19%. Directors can then minimise their personal tax and National Insurance Contributions (NIC) by paying themselves a mixture of a salary and dividends. Broadly speaking, limited companies are often more tax efficient than sole traders. In addition, there’s a wider range of allowances and tax-deductible costs that a limited company can claim against its profits. Sole traders do not have the same tax benefits. They pay 20-45% Income Tax on all taxable earnings, as well as Class 2 and Class 4 National Insurance.

The third benefit of incorporating your business is that you will seem much bigger than perhaps you are. This can be important when a potential client or customer is researching their options.

Step 2 What’s in a Name

A lot of people get bogged down with this when, in reality, you can trade as anything you like.  Honestly, if you can’t think of a name, use your favourite colour, followed by your favourite shape or animal. There are, of course, some other considerations; you may want to see what web addresses are available or similar URLS used by a direct competitor but this doesn’t stop you registering your company in the first place. You may also want to buy your favourite web addresses in advance, no harm in planning ahead.

Step 3 Shareholders v Directors 

If you have decided on a limited company structure and have chosen a name, you then need to identify shareholders, who own the company and directors, who will run the company. Often they are one and the same, but there is no requirement for them to be so. For example, a business may be owned by husband and wife but in reality it is the wife’s business and she is the sole director. The reason the shareholding is important is that any dividends paid out need to be in proportion to share ownership. If it is a 50/50 split, then one director can’t be paid 100% of the dividends.

Step 4 A registered office 

Next, you need to set up a registered office, which can be your house, or preferably your accountant’s. If someone wants to offer you a sizable contract, it helps that your business has a recognisable address, and not just your shed!

Step 5 Bank Account 

It is very important that you set up a business bank account that you treat as 100% separate from your own. It is NOT your money until you pay it out to yourself! Even as a Sole Trader, you need a separate account. As a limited company, as a separate legal entity, it is important to make a distinction between what’s yours and what is the companies.

Step 6 Payroll 

If a business owner intends to pay themselves or any other employees more than £113 a week, they should first register for a payroll scheme with HMRC. Businesses can choose which payroll system to use and it will help record employees’ details, work out employees’ pay and deductions, report payroll information to HMRC and calculate statutory pay, for example, maternity or sick pay.

Step 7 VAT

A lot of people don’t want to register for VAT because they see it as an extra burden. You have to do a return every quarter. And, if you deal direct with consumers, then potentially you become 20% more expensive than your competition. But if you are Business to Business (B2B) then you are VAT neutral. Your customers are able to claim the VAT back and you can recover the VAT that you are spending. So really as a limited company, services business customers, there is no reason not to do it. The thing about registering for VAT is that it gets you into good habits by making you do your accounts each quarter in order to file the return.  It often makes your business look a lot bigger than it actually is, offering it a level of kudos. Of course, if you are fundamentally scared of your bookkeeping, you should outsource it immediately and let someone take care of it for you.

But in reality, using a cloud-based solution like Xero, the quarterly VAT returns can almost be a simple as pushing a button.