Business : Incorporation - Taking cash out of your business

In earlier blogs in this series I have highlighted some of the key issues you need to consider before deciding whether to run your business through a limited company.

In this blog I will focus on the way that the tax rules differ as regards the money that you take out of your business. This depends on whether you run your business as a limited company or as a sole-trader. The tax rules for partnerships and LLPs are much the same as for sole-traders although partners can avoid arguments if they agree between themselves things such as who can take money out of the business, when they can take it and how much they can take.

When you're self employed (which gets referred to as being a sole trader) you may have a business bank account or you may just bank your business income in your current account. It can be a good discipline to have a separate business bank account but it's not critical. As far as you're concerned the business's income is your income and you pay income tax on the business results regardless of the level of your drawings.

That's so important that it bears repeating. Sole traders are taxed on their business profits regardless of how much money they have drawn out of the business for personal use. This means that drawings are not deducted from taxable profits so it doesn't matter how much you take. Your business profits are all taxable regardless of how much is left in the bank, reinvested in the business or used to repay loans. As a sole trader you pay 'income' tax on your taxable 'income'.

After a business has been incorporated as a company however the rules are COMPLETELY different so far as the owners are concerned. You need to understand that you can no longer dip into the company's bank account for your 'drawings' as this is no longer your money. This may seem crazy as you own the company and you probably still think of it as your business. However once the business now belongs to the company the position is different as the company is a separate legal entity and so quite distinct from you the owner. This is a key issue that everyone who incorporates their business into a company needs to understand.

The company will pay 'corporation' tax on it's 'corporate' profits. These profits are computed by deducting from the company's income all legitimate and allowable business expenses. These include remuneration, salaries and 'benefits' paid to employees and directors. When you incorporate your business into a company you inevitably become a director (and therefore an employee).

Companies cannot however deduct dividends from their taxable profits. Dividends are paid out of what's left after the company has paid its corporation tax.

Coming back to the topic of this blog posting, you will be subject to different tax consequences depending upon the nature of any monies paid to you or that you draw out of the company. The impact and timing of these tax cashflows should be factored into your plans when you incorporate your business as a company. Simply stated:

• earnings - these need to be recorded and paid through the PAYE system. Income tax and employee NICs will be deducted and paid to HMRC by the company together with employers' NICs. The payment of earnings will reduce the corporation tax subsequently payable by the company;

• dividends - can only be paid out of distributable profits by reference to a formal resolution in accordance with the company's Articles of Association and preferably evidenced by a simple dividend voucher. Dividends are not deducted when determining the level of corporation tax payable by the company. Higher-rate taxpayers will have to pay tax on their dividends;

• repayment of Director's loan account - only applicable if the company owes money to the director. This is most commonly the case if the business and assets are sold to the company on incorporation.

• loans to the director- the default alternative. These can be complicated for a number of reasons.

Loans to directors are technically prohibited by s330 Companies Act 1985 (although loans of upto £5,000 are permitted by s334). Loans to shareholders and other 'participators' in most smaller companies must be matched by, in effect, a loan of 25% of the sum involved to HMRC. This 25% 'tax' is recoverable from HMRC when the loan to the shareholder is repaid. Interest is charged for any period during which the 25% tax should have been held by HMRC.

Finally loans to directors are generally subject to tax on what is deemed to be a benefit in kind. That is the interest-free nature of the loan. Thus income tax will be payable on the deemed benefit of an interest-free loan provided by the company.

If you've already incorporated your business and run it through a limited company I'd be interested to know how you feel about the administrative rules and burdens I've summarised above. Equally, are you one of the people who decided NOT to run your business through a limited company because the tax rules would work against you as regards such matters?

You can read all the blogs in this series by following this link.


Mark Lee FCA CTA (Fellow)
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