Income and Drawings
Extracting money from your business
Once clients have paid their invoices, there are various things you can do with the money sitting in the business account:
- Use it to pay bills, expenses or taxes
- Keep it in the business for a rainy day or to invest in growth
- Extract it from the business for your personal use
Extracting money: Sole Traders and Partnerships
Extracting money from the business is straightforward if you’re an unincorporated business (i.e. you’re self-employed rather than a company). Any profit left over after tax can be drawn from the business account if you wish.
To calculate the taxable profit:
- Add up your invoices (excluding VAT)
- Add up all your legitimate business expenses (excluding VAT)
- Subtract the expenses total from the invoice total – that’s your profit.
Set aside any money for tax and bills that you owe (plus VAT if applicable – see the section on VAT). Any money left over is yours. Note that partners in a partnership are taxed on their share of the profit.
Extracting money: Limited Companies
If you run a limited company, the money received by the business isn’t yours. It still belongs to the company. To transfer any profits to your personal bank account you need to formally record the transaction as either a salary or a dividend.
When you receive a salary, your salary is subject to certain taxes that must be accounted for by your limited company. They are:
- PAYE (Pay As You Earn) Income Tax
- Employee’s National Insurance Contributions (NICs)
- Employer’s National Insurance Contributions (NICs)
In addition, the Real Time Information (RTI) legislation means that you have to report the salary payment details on or before every occasion your salary is paid. This applies to all employees on your company’s payroll, although companies with less than 50 employees will benefit from a less restrictive reporting regime until April 2014. It is important to discuss this with your accountant in order to agree a process that complies with the law.
The process for paying yourself is usually as follows:
- Decide how much to pay yourself each month. They can be varying amounts, but usually people set a monthly amount payable on a fixed date - this can be topped up by one-off bonuses as needed.
- Give your accountant or payroll administrator advance notice of the salary amount and date so that they can issue a monthly pay slip and file the RTI report with HMRC.
- Transfer the amount from the business to the personal account on the agreed date.
- Record the transaction as salary on your bookkeeping system, including the date and the amount.
- Pay all three taxes (PAYE, Employee’s NICs and Employer’s NICs) to HMRC from the business bank account – this is usually done monthly by direct debit. Your accountant can advise on the due dates. These payments must be made electronically and the cleared funds need to be in HMRC’s bank account by the 19th day of the month after the salary was paid.
Paying yourself a dividend
Dividends can be paid to the owners (shareholders) of a company from the retained (post tax) profit provided that the correct procedures are followed. This involves the Board of Directors having a meeting, formally voting the dividend and providing a written record of that decision. There must also be documentation in the form of a dividend voucher which is then issued to the shareholder(s).
The advantage of paying yourself dividends is that neither employee nor employer NICs are payable. However, the dividends cannot exceed the retained profits of the company. Your accountant can assist you with calculating funds available for distribution and preparation of the appropriate paperwork.
Dividends can be declared as often as you like, although if you are paying yourself regular dividends of the same amount (e.g. £1,000 once a month) there is a risk that the taxman could reclassify the payments as salary, which would negate any benefit from receiving dividends upon which neither employee nor employer NICs are payable.
The payment of a dividend should be completely separate from other payments; i.e. do not fall into the trap of transferring one monthly amount from your business to your personal bank account which is a composite figure of salary, expenses and dividend. If HMRC see such a payment, they may try to argue that it is all salary!
The value of the gross dividend which can be distributed depends upon the realisable profit of the company. In any one year, the realisable profit equates to the Company income less Expenses + Corporation Tax. Bear in mind that some of the realisable funds may need to be invested in the business.
Deciding whether to pay salary or dividend
As a company director you can decide how and when you are paid. There are various strategies for doing this based on the relative tax implications. If you haven’t drawn up a contract of employment between you and your company (and you’re not obliged to), then you are not subject to the National Minimum Wage rules, which means you can set a salary of your choice.
Some freelancers opt for a policy of taking a low salary and topping it up with dividends. The salary will be between £5,668 and £7,696 for the 2013/14 tax year, as any salary between these two points ensures a credit for NIC purposes which helps in terms of future state pension and other benefits, whilst remaining below the point where the salary is taxed. This takes advantage of the lower rate of tax for dividends. Not everybody operates this way – your accountant can advise on the best route for you.
Another factor to consider is corporation tax. Any salary you pay yourself is an allowable expense, which reduces the company profit and consequently the corporation tax due. Dividends can’t be claimed as an expense, so they don’t reduce corporation tax.
How you pay yourself should also take into account a number of factors including your pension provision and the amount of money you wish to retain in your business for future investment.
Paying salary to a partner or spouse
Until 2007 HM Revenue & Customs (HMRC) attempted to penalise businesses where one partner was the main fee earner and the other received dividends or a profit share. Many freelancers do this in order to benefit from their partner’s tax allowance – if two people each declare £30K income, they pay a lower rate of tax than one person who declares £60K.
The tax authorities tried to prevent this by re-interpreting an old piece of legislation known as ‘S660A’. IPSE fought off what later became known as the ‘Family Business Tax’ by supporting the landmark Arctic Systems case all the way to victory in the House of Lords.
As a result of the court case, it is still legal to pay a partner as described above – however, the law could change and it’s important to keep an eye on it.
HMRC’s new RTI rule: how it affects freelancers and contractors
From 6th April 2013, the vast majority of employers must report PAYE in real time. HMRC believes this will make the PAYE process simpler by removing the need for the end of year returns (P35 and P14), although the information will still be reported via RTI.
So how does RTI affect freelancers, contractors and other independent professionals?
If you operate via a limited company and pay yourself a salary, then the new legislation means you will have to report the details on or before every occasion your salary is paid. This applies to all employees on your company’s payroll.
RTI does not apply if you are a sole trader or partnership, unless you also have employees.
Penalties and Concessions
HMRC expects most employers to be reporting PAYE electronically in real time from their first payday on or after 6th April. There will be no concessions for employers operating in areas with no broadband connections, although there will be some exceptions for employers on religious or ethical grounds.
There is a temporary relaxation which gives businesses with less than 50 employees extra time to adapt their processes. However, they are not exempt from RTI and will still need to report payments by the end of each tax month (5th) at the latest. This concession ends on 5th October and from 6th October 2013 all businesses must report in real time.
HMRC has stated that they will “continue to work with employer representatives during the summer to assess and understand the impact of RTI on the smallest businesses and consider whether they can make improvements to real time reporting”. There will be no penalties levied in the 2013/14 tax year for employers who work with HMRC to get things right.
Detailed guidance: IPSE’s Guide to RTI
Have you discussed the changes with your accountant or payroll provider? IPSE’s Guide to RTI provides more detailed background to help you have an informed conversation and adapt your processes as necessary.Getting paid, Managing your money, Starting Out