April 30, 2012
Now that the top income tax rate is definitely being cut to 45% and we know this will take effect on 6 April 2013, clients may be wondering if they can avoid paying the 50% rate altogether. For some taxpayers, the 50% tax rate coupled with the withdrawal of the personal allowance for higher earners has meant they have been taxed at an effective rate of 62%. This happens where total income falls into the £101,000 to £113,000 band where the erosion of the personal allowance has the biggest impact.
For many it is possible to delay receiving income until the 45% rate takes effect – this really depends on how much flexibility you have over how you receive your income. What we are suggesting as tax advisers is to weigh up the viability of temporarily reducing your income for the current tax year, until the 50% rate is removed.
Tax planning like this obviously needs to factor in two things: can you afford to be flexible and potentially survive on less money this year to cut your tax rate for longer-term gain? And do you have the ability to influence the ways you can take your income?
Assuming the answers to those questions are yes, here are some tactics you can consider. We would always suggest you discuss the ramifications with one of us beforehand, but this list will give you some useful food for thought.
#1 Incorporate your business
A very good way to shelter excess income from higher rate tax is through a limited company. A limited company provides flexibility which is not available to sole traders or partnerships, therefore clients who are sole traders or members of partnerships or limited liability partnerships (LLPs) should consider incorporating all or part of their business.
Running your business as a limited company (by incorporating) offers many tax planning opportunities. This is primarily because of the additional flexibility offered over the way your income can be taken, for example as salary, benefits or dividends.
#2 Use and manage your director’s loan account
For those running their business through a limited company, routing dividends through their director’s loan account can be useful for spreading income. A director’s loan account requires careful monitoring because if it goes overdrawn for any reason, there are adverse tax consequences both for the director and the company. Overdrafts such as these can be minimised (or even avoided) if loan accounts are monitored and reviewed on a regular basis and any necessary action required to minimise tax is taken.
The status of a director’s loan account should always be reviewed both at the company’s year end and at the tax year end, in line with directors’ income levels so that any necessary adjustments can be made, and to provide maximum opportunity to reduce tax liabilities. Whilst it is possible to do this after the company’s year-end, or when the accounts are being prepared, there is less scope to reduce the tax liabilities arising because planning options are significantly reduced. It is worth discussing this with us sooner rather than later to see what steps might be taken.
#3 Income equalisation
How might you be able to reduce your income but maintain your existing standard of living as much as possible? If you are an owner director with a non-working spouse, one option to consider is income equalisation. Can this be done through salary or dividends? This will depend on the facts of the case, but should certainly be considered.
#4 Consider tax efficient investments
Another possible tax planning option, for those with excess income, is to consider a tax efficient investment option in an approved small enterprise. Provided you have a well-diversified investment portfolio and understand the risks, Venture Capital Trusts (VCTs) or investments through the Enterprise Investment Scheme (EIS) or the new Seed Enterprise Investment Scheme (SEIS) may be suitable and will help to reduce your income tax liability for the year.
Especially of interest for business owners thinking about their next venture, it is possible to invest in your own start up company through SEIS with your own funds as an owner director. This is a very attractive opportunity and the main qualifying condition is that the venture must be a completely new entity to qualify. We have covered SEIS in detail this month, read our other article for more information about this scheme.
#5 Consider longer term investments
Interest arising on funds invested becomes taxable when the income is credited to the account. Often investments will be made for a fixed term, with the interest accruing once the fund reaches maturity. If this maturity date arrives before 6 April 2013, the interest will be taxable at 50% for those with total income over £150,000; if the fund matures after that date, the tax rate will be 45%
#6 Maximise tax relief on pension contributions
There are issues with pensions currently due to interest rates being so low, but in spite of this, they remain a very tax efficient investment. You might want to consider reducing your taxable income levels by increasing pension contributions and making use of the maximum tax-free allowance. This can have a double benefit because in addition to reducing your personal tax rate, limited companies can obtain corporation tax relief on pension contributions of up to £50,000 a year for each director. There may also be an opportunity to bring forward unused contributions from previous years, but this needs to be analysed carefully as the legislation surrounding this area is complex.
If you would like to discuss these ideas in more detail, please email Lesley Stalker at [email protected].