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With many entrepreneurs accumulating cash in business accounts, the question of “how to invest business profits?” is a favored topic when planning.
Entrepreneurs work hard for their businesses and this short article explores how business funds can work hard- or most effectively, for entrepreneurs.
Let’s take the following scenario: your business is profitable and has accumulated cash. During the years of trading, you have typically drawn an annual salary and dividends of £45,000, a point at which you are paying the basic rates of tax. Now with a stockpile of cash in the business, there are two options through which to invest. Should you personally draw additional funds from the company to invest, or alternatively should you invest from within the corporate structure?
Assume in both cases there is a £50,000 cash surplus in the company. Assume also that this happens every year for the next 10 years.
To take the money out of the company, you would pay dividend tax of 32.5% upfront. You (and perhaps your partner) could then invest your money tax-free, say in an ISA wrapper, in which your combined ISA allowances are currently £40,000.
Investing the money within the company would mean no upfront dividend tax of 32.5%. You would instead pay corporation tax on the investment income and gains annually, with the caveat that dividends received from stocks and shares are mostly exempt from corporation tax. This is a considerable advantage.
Let’s see how the two strategies fare:
As you can see, investing the money in a limited company yields approximately £180,000 more over a ten-year time horizon. The cost of paying the dividend tax upfront outweighs the benefit of tax-free personal investments. Why should you lose out?
You will notice immediately from the graph above that investing your company’s profits in the corporate vehicle, without paying dividend tax, allows the investment to accumulate, or compound, at a faster rate, even after paying corporation tax on investment income and gains.
Sure, if you do not draw the surplus funds from your company you may need to take a 32.5% dividend tax rate hit at a later date, but in the interim you will have generated greater income through compounding.
Here we assume constant tax rates at the points of execution, income and realisation. It would be unwise to speculate on domestic policy, but current political trends and economic philosophy may see a conservative government try to enforce its stronghold on previously labour heartlands. Corporation and dividend tax rates could well rise before they fall.
You may find that transaction costs are slightly higher for corporate accounts, chipping away at annual returns. You will need to shop around harder for a broker. Equally personal brokerage accounts tend to be more insurable than corporate accounts.
If the preference for investing through a Limited Company has been established, so should the mechanism through which to do so. Yes, you could simply open an investment account for the existing trading company, however there are several reasons why a designated investment company is superior:
Whilst the trading company is often the vehicle in which profits have been generated and accumulated, there are tax neutral ways of shifting funds to an investment company, such as lending the cash surplus. There is no obligation to pay back the loan and one can be the sole director of both companies.
A holding company structure that owns operating companies and receives dividends is favourable. The holding company can own shares in the subsidiary trading companies and can provide centralised corporate control. Additionally, no taxes would be incurred when the trading company is sold.
If you want to invest in property it may be a better idea to set up an SPV. This is often a requirement from buy-to-let lenders. If you are looking to acquire a primary residential residence however, personal ownership is often the best way to go.
Your investment goals will seek a level of risk and return that you are comfortable with, regardless of the structure through which you pursue them. The tax wrapper is the “cherry on the top”, though worth a certain percentage of your annual returns. Contact Mouktaris & Co Chartered Accountants for an accountant who understands your investment strategy and can help you plan accordingly.