For some business owners, it's the perennial problem, what do you do with excess company profits?
First, just like with your own personal finances, you always want to have a capital float for planned, and unplanned, large expenditures. That goes without saying for good planning.
So let's assume you have that in place, and that you don't need to re-invest in the business.
What do you do with the rest? and with the expectation that this will crop up again every year?
You've got four choices:
Leave it in the business bank account.
Put it in a business deposit account.
Invest it in a corporate investment.
Put it into your pension.
Let's take each in turn.
So now we know this, let's talk strategy.
Company profits - Strategy One
Some business owners intend on leaving excess profits in the business, and then plan to withdraw the cash when they sell the business, and benefit from a reduced 10% Capital Gains Tax rate, due to Business Asset Disposal Relief (BADR), which used to be known as Entrepreneur's Relief.
For most businesses, this is a viable option. But if you do go down this route, you still need to know what you will do with the cash in the meantime. In which case, you'll need to decide between options 1, 2 or 3, or a blend of these options.
Company profits - Strategy Two
Most business owners hate paying more tax where possible, you already get taxed a lot right?
Because of this, some business owners instead fund their pension as much as possible each year, primarily due to the tax efficiency of employer pension contributions being an allowable business expense, and thereby reducing the amount of profits liable to Corporation Tax in the first place.
The added upside? it diversifies away your own personal wealth from the business.
If you were planning on a nice big sale valuation when you come to retire, it's a lot stressful extracting the value you think you're owed if you have a healthy pension to fall back on.
Let's play out the two different approaches/strategies with an example business owner.
Patrick, is aged 45, and owns PR123 Ltd., a PR company, which make profits of £100,000 a year after all staff remuneration. He likes to take £40,000 dividends a year to top up the salary he pays himself.
Approach One & Two Compared
What are the differences?
He has more left in the business in Approach One, however, he's paid £13,250 more in Corporation Tax for the privilege.
In Approach Two, he has put £50,000 into his pension, hopefully to grow ahead of his retirement, plus left £500 in the business.
In both cases, he's taken out the dividend he wanted.
What does the long-term picture look like?
After 10 years, he'll have put £500,000 into his pension in the pension scenario. He'll have paid £95,000 Corporation Tax.
In the no pension scenario, he'll have £377,500 in the business bank account, and paid £227,500 in Corporation Tax.
So on the face of it, leaving the money in the business is a bad idea.
But what about what compounding does to the money after 10 years, and what about the tax you would pay on getting the money out of the business, or out of the pension?
Let's look at three scenarios:
He gets no growth on the money in the business bank account - he simply leaves it in the same bank account and does nothing with it
He moves it around attains a 4% return/interest each year in a business deposit account.
He invests it in the pension and gets a 4% return each year.
Scenario 1:
Patrick builds up £377,500 in total, then pays 10% Capital Gains Tax and takes it all out as a lump sum, and gets £339,750.
Scenario 2:
Patrick builds up £471,360 in total, which is the same £377,500 as in Scenario 1, but with added interest at 4% a year.
He'll then pay 10% CGT and get £424,224 out.
He's ultimately got around £95,000 more out by making sure he's got a good level of interest/return in those 10 years with the retained profits.
Scenario 3:
Patrick builds up £624,318 in his pension.
If he took his pension out as income under UFPLS rules (which means he'll take a bit of tax-free cash income with each taxable income payment), and he is a basic rate tax payer in retirement, Patrick will pay an effective tax rate of 15%.
Because of this higher tax rate on a higher amount of capital, he'll pay more in tax - £93,468 - but he'll get £530,670 out over time.
By far and away, the highest level of drawing from the business overall when compared with the other two scenarios.
What do I do now?
It is clear from the figures that putting excess profits into pension is the most tax efficient route for most business owners, and even more so for those businesses who do not qualify for BADR when they sell, such as some companies involved in property.
If you put money into pension, you need to work out how to invest it and how much risk to take.
You also need to be aware that you won't be able to draw it all out as one lump sum at retirement without being heavily taxed.
Whereas if you take it all out as a lump sum from the business at the point of sale, you then need to decide what to do with it. For some people that flexibility is useful, for others it proves a challenge to work out where to put it, to provide the required income for whatever comes next, probably retirement.
Action - work out whether you would prefer to keep it in the business or put it into a pension. Either way, you need to make sure it is working for you and is growing or earning interest!
We help lots of Business Owners be tax-efficient and plan for the future, be it post-exit or retirement.
If you'd like to talk to us about providing you with personalised financial planning to help with this, you can book in an initial consultation here:
Otherwise, see you next time.
The information contained within this blog post should not be taken as financial advice, as it does not take account of personal circumstances, which would affect advice given. Should you wish to talk to us about personalised advice for you, we'd be happy to do so.
Tax rates are based on the tax year 2023/24.