1. Profit from Self Employment (or Partnership).
This is actually quite straightforward, for an accounting concept! If you are self employed then you are the company (technically known as the same legal entity). The business’ money is your money so theoretically you can just take it when you want.
- Drawings and Capital Introduced
When you take money out it is known as Drawings and when you put money into your business it is known as Capital Introduced. When your accounts are produced at the end of the year as part of your Balance sheet you will get total figures for your Drawings out and Capital introduced during the year.
- Don’t Forget
There are a few important things to bear in mind when you do take money out of the business:
Be able to cover your debts – Just as the business’ money is your money, so are the debts. If you don’t leave enough money to pay the business debts you will be personally liable for them.
And your tax – This also counts for tax. All your self employed profit counts as personal income and counts towards your personal allowance (the money you as an individual can have without being taxed). Even if you have no money in your business bank account you could still owe tax. Tax is harder to work out as you don’t always know straight away how much it will be, but you can really help yourself if you make some kind of provision as you go along e.g. save 20% of profit after regular expenses are deducted.
What about wages? – When you are self employed, the drawings are the equivalent of your wages. You don’t have to register a PAYE payroll with HRMC unless you are employing other people.
2. Profit from Limited Company
This is where things get a bit more interesting. You are not your Limited Company; even if the Limited Company is just you as the only Director and Shareholder, it is a separate legal entity. This means all the profits belong to the company and not to you personally.
There are two ways that you can take money out of your Limited Company: wages and dividends. I like to think of them as a two layers (use a cake or sandwich image – whatever works for you).
- First layer – Wages
The company can register a payroll with HMRC and pay you a monthly or yearly salary. You can pay yourself as much as the company can afford in wages, however most people stick to a salary below or equal to the National Insurance Primary Threshold level.
If the salary is above the NI Primary Threshold level then you will start to lose some of the wages to an employees National Insurance deduction and the company will start to owe employers National Insurance on top of the wage payments and deductions.
Any wages you take from the company need to go on your personal tax return as employment and count towards your personal allowance (the money you as an individual can have without being taxed).
If you take more than your personal allowance limit in wages, you will start to get PAYE tax deductions through the payroll as you would in any other job.
You don’t need to physically pay yourself the exact wage amount if you don’t want, it can just get balanced with your Director’s loan account at year end (see below for a proper explanation).
- Second layer – Dividends
Dividends sound very technical and remind me of stock markets and investments but the easiest way is to think of them as the equivalent of drawings for limited companies.
Dividends are generally declared at the end of the financial year. This is because a company can only give dividends from the profit after Corporation Tax. So the company needs to know how much profit it has before the final dividends figure can be calculated.
This doesn’t mean that you need to wait until the end of the year before you can take any money. You can borrow against your future dividends via your Director’s loan account. What this means in practise is that you take money out of the company during the year. At the end of the year when your accounts are done this will all be totalled up. Your accountant will count the first chunk of this amount as your wages and the remainder will be your Director’s loan, representing what you have borrowed from the company. To complicate things a little there may technically be interest payable on borrowing against the Directors loan over £10,000 (£5,000 in 2013-14) otherwise the interest free loan from the company would count as a benefit in kind on your personal tax return. Again your accountant can help with this.
As a Director, you are not allowed to end the financial year owing money to the company so dividends are declared to cover what you owe in your Director’s loan account, bringing it to zero so that everything is nice and squared off.
You do have to put the dividends on your personal tax return as well as your wages. Because the dividends are declared from the profit after tax, they have already been taxed once so you don’t get taxed on this income again. (There is a rather strange system of being taxed and then getting tax credits that you might see on your tax return but the overall outcome is generally zero tax on dividends unless you are a higher rate tax payer).
UPDATE – This is changing after April 2016. You will get £5,000 dividend allowance with a tax rate of 0%. It does not matter whether you are a basic rate taxpayer, higher or additional rate taxpayer, everyone gets the £5,000 at 0%. Any dividends above £5,000 will be taxed at 7.5% for a basic rate taxpayer, 32.5% for a higher rate taxpayer and 38.1% in the additional rate band.
- Don’t forget
Make up the first layer of your Limited Company income with wages up to the NI Primary Threshold level and then the second layer with dividends.
Really important, before you get free and easy with your Director’s loan account!
Remember the tax – you can’t take all the money that you earn out of the company via your Director loan because dividends are declared on profit after tax. You always have to leave enough in the company to pay your tax bill. The best rule of thumb is to put aside 20% of income after any wages and regular monthly expenses are deducted each month. If you don’t leave enough to cover the tax then you won’t be able to clear the Director’s loan account and the company will owe tax on the amount remaining.