Maximum Tax Efficiency

Business owners can adopt various strategies to achieve maximum tax efficiency, depending on the type of business. The most common types of businesses are sole proprietorships, partnerships, and limited companies. Here’s how business owners of each type might be paid for maximum tax efficiency:

Sole Proprietorship: A sole proprietorship is the simplest form of business where the owner is the sole operator and personally responsible for all aspects of the business. The self-employed business owner takes income as “drawings” from the business profits. To achieve maximum tax efficiency, the business owner should consider the following:

a. Personal Allowance: Utilize the tax-free personal allowance, the income one can earn each year without paying income tax. The personal allowance for the 2021/2022 tax year is £12,570.

b. National Insurance Contributions (NICs): Keep income below the threshold for paying Class 4 NICs to minimize the overall tax burden. For the 2021/2022 tax year, the threshold for Class 4 NICs is £9,568.

Example: A sole proprietor might aim to keep their income at £12,570 to utilize the personal allowance while minimizing their exposure to NICs.

Partnership: In a partnership, two or more individuals jointly own and operate a business. Partners share profits and losses and pay tax on their share of the partnership income. To achieve maximum tax efficiency, partners should consider the following:

a. Personal Allowance: Partners can utilize their tax-free personal allowance like sole proprietors.

b. Profit Allocation: Partners can allocate profits tax-efficiently, considering each partner’s tax band and personal circumstances.

Example: In a partnership with two partners, one might be a basic rate taxpayer, while the other is a higher rate taxpayer. The partners could allocate a higher share of profits to the basic rate taxpayer, reducing the overall tax burden on the partnership income.

Limited Company: A limited company is a separate legal entity from its owners (shareholders) and is governed by a board of directors. Directors can be paid through a combination of salary and dividends, providing flexibility for tax planning. To achieve maximum tax efficiency, company owners should consider the following:

a. Optimal Salary: Paying a salary that utilizes the personal allowance and keeps the income below the threshold for employees’ NICs. For the 2021/2022 tax year, the primary threshold for employees’ NICs is £9,568.

b. Dividends: The remaining profits can be distributed as dividends once an optimal salary is paid. Dividends are taxed lower than salary and do not attract NICs. The dividend tax rates for the 2021/2022 tax year are 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers, and 38.1% for additional rate taxpayers.

Example: A company owner might pay themselves a salary of £9,568, avoiding employee NICs, and then take the remaining profits as dividends, benefiting from the lower dividend tax rates.

In summary, the optimal method of paying business owners for maximum tax efficiency depends on the type of business. Sole proprietors and partners should utilize their allowance and minimize NICs, while limited company owners should consider a combination of salary and dividends. Consulting with a tax professional or financial advisor can help tailor the strategy to individual circumstances and maximize tax efficiency. You can call us to discuss your personal circumstances with our specialist tax advisors.