ebrief for freelancers and contractors Contractors guide to investing surplus cash

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1 ebrief for freelancers and contractors Contractors guide to investing surplus cash

2 Making the most of your Surplus Cash Intouch Accounting, the personal online accountant, looks at this all important question frequently asked by contractors and freelancers. Should I leave surplus money in my limited company and, if so, what should I do with it? We consider surplus money left in the company after you ve taken out what you need personally and after all company taxes. We also look at what you can and can t do with this surplus cash. So read on and make sure you re not missing out on all the financial opportunities available to you. 2

3 What is Surplus Cash? Each year your company generates income from which business expenses, your salary, and corporation tax are deducted, as are dividends that you decide to declare. This leaves a net surplus or a deficit for the year. This amount is then added to the running total brought forward from all earlier years (if there are any), which will have been calculated in the same way, giving your accumulated surplus cash or retained profit at the end of the year. From the outset it s also worth explaining that any surplus cash you leave in the company is only taxed once, and that s in the year the profit was first made. So it s not taxed again just because it s left in the company. Going forward your company will pay corporation tax on any income or gains made by investing this money, but not on the original sum itself. Remember, the cash balance in the bank is not always the same value as retained profit. Usually there are invoices where the cash hasn t been received or some expenses or taxes that are still to be paid. It s easy to forget, for instance, that corporation tax is payable a long time after the end of the year. So there will be tax liabilities outstanding and your bank balance will include profit for the current year that s not yet even been taxed. In short, beware of timing differences. Any surplus cash you leave in the company is only taxed once, and that s in the year the profit was first made. So it s not taxed again just because it s left in the company If you want to see what your retained profit was at your last year-end date, take a look at the Balance Sheet page of your accounts. At the bottom you ll see a value for Profit and Loss. Of course, the up to date retained profit changes each day as income, expenses and dividends occur. 3

4 Why are profits left in the company? Individuals are taxed personally on income when it s taken out of the company, either as dividends or salary. Your income can be taxed at quite high rates, 40% if you are a higher rate taxpayer and 45% if you are an additional rate taxpayer, so there s no point taking money from the company and incurring these higher tax rates until it s really necessary to do so. It s far better to leave company profits you don t need in the company and pay corporation tax at 20%. However, there are circumstances when the general advice to leave surplus funds within your business does not apply. In these circumstances it s better to take the cash out of the company where: 1. The company can t make the investment you want to make, or 2. The value of the allowances you get as an individual far outweigh the lower tax you pay in a company, or 3. Lower rates of personal Capital Gains Tax apply. Otherwise follow the general rule: it s usually better to invest funds directly within the company. But we would always recommend that you discuss each investment decision in detail, according to your individual circumstances, with your financial services adviser and your contractor accountant. Remember, the cash balance in the bank is not always the same value as retained profit. Usually there are invoices where the cash hasn t been received or some expenses or taxes that are still to be paid. Note: if you are one of those contractors making more money than you need to meet your personal expenses, the general best advice is always to leave your surplus income in the company until some future date when you need it. Be aware that future tax rates can be worse than current ones when it is time to extract the cash. But they could also be better! 4

5 So, what can I do with the Surplus Cash? 1. You could create an investment portfolio. Over the years we have seen a range of investments undertaken by contractors, but the most common and frequently seen are: a. Residential buy to let. b. Buying property through the company. c. Share trading. d. Foreign currency trading. e. Bonds, loans and short and long-term deposits. f. Investments in other business activities. Each and every one should be considered carefully and after taking appropriate advice, and you should be aware that some investments are regulated investments. It s worth noting that activities such as buy to let and commercial property activities are generally accepted as trading activities, as would be share and foreign currency dealing. Passively holding listed shares, bonds or other loans or deposits tend to be more in the nature of non trading; but holding shares in another small trading company may, in the circumstances, avoid being deemed an investment company, but it depends...! Different investments have different risk and return profiles. It s important when considering making any investment to take the appropriate advice and make sure the product suits your needs. This includes consideration of the tax consequences, including whether income is a trading profit or a gain, and what allowances may be additionally available to you. 5

6 Regulated and unregulated investments Where an investment is regulated, advice pertaining to it can only be provided by a financial adviser regulated by the Financial Services Authority (FSA). Some advisers are tied to a particular provider, yet Independent Financial Advisers (IFA s) are not tied to a single provider and can go out to the whole market to select and advise upon a range of investment products. Often contractors appoint advisers that are recommended to them; this is by far the best approach. Remember, advisers get paid either from fees charged to you, or by taking commission from the provider, or sometimes both, so be careful when negotiating and selecting the product. You need to ensure they know enough about you as a contractor to understand your objectives. Each and every investment should be considered carefully and after taking appropriate advice, and you should be aware that some investments are regulated investments 2. You could fund a pension. A pension is a regulated investment. It s also something you probably would be better off doing in your existing company, as tax relief is available for contributions paid during an accounting year. There are many contractors who don t like pensions, and we have often seen contractors build up buy to let portfolios as an alternative way of securing assets and income for their retirement. 6

7 3. You can establish a retirement company. Some contractors create a separate retirement company, distribute dividends to that company and invest those funds for the future. The retirement company receives surplus income by dividend from the contracting company, and as these are received net of corporation tax there is no further tax payable. The money can then be invested in a range of ways, selected by the contractor in order to generate either income or gains. Corporation tax will be payable on any income generated, or when a taxable gain is realised following the sale of an asset. The retirement company is usually owned by the contractor and, once the contractor retires, dividends can be declared and paid to the contractor as a form of pension. If you want to understand tax on dividends then please refer to our dividend ebrief, but needless to say dividends within the basic rate personal tax band attract no further tax liability. A pension is a regulated investment. It s also something you probably would be better off doing in your existing company, as tax relief is available for contributions paid during an accounting year. This constitutes an interesting alternative to formal pension contributions. Here you have more control over the assets and the income, and how quickly or otherwise the money is paid out. But it remains one that should only be considered in the right circumstances, having taken appropriate advice from a financial adviser. 7

8 4. You can loan the funds with or without interest. It s not generally a good idea for you or your family to borrow money from your company, because the company will be subject to a special kind of corporation tax calculated at 25% of the loan. This special corporation tax is actually also a form of loan and repayable to the company by HMRC, but only after the loan has been repaid by you (or your family) to the company. However, there are circumstances where taking a loan from your company makes sense. For instance, if in the short term, you have an opportunity to make a personal capital gain that can be covered by your personal annual exemption, or where it s possible over a relatively short period to accumulate gains at the lowest personal capital gains tax rate of 10%. It s not generally a good idea for you or your family to borrow money from your company, because the company will be subject to a special kind of corporation tax calculated at 25% of the loan. In these circumstances, taking a loan from your company for the period required to make the gain, and then repaying the loan to the company once the gain has been made, suffers only the loss of the use of the 25% tax paid for the period held by HMRC. There is can also be a small tax cost associated with interest free loans, but that could be avoided by paying some interest on the loan to your company. 8

9 5. You can accumulate your surplus cash prior to closure In certain circumstances, keeping assets in the bank or on deposit, allowing for immediate access, can be a preferred option, especially where interest rates are low, or you have a low appetite for risk or perhaps where your exit from contracting is in the near future. When a contractor chooses to retire or to terminate the operation of the business trade, specific but very standard tax rules apply. You can simply close a company and take the final funds as a capital gain, provided they don t exceed 25k. The rate of Capital Gains Tax will be 10%, provided the gains qualify for Entrepreneur s Relief, whereas income tax could be as high as 32.5% of the gross dividend. You ll also benefit from your annual Capital Gains Tax allowance, which will reduce the tax even further. Above 25k, you need a formal liquidation. The additional costs generally outweigh the tax benefits until you get to over 50k. Although with the cost of liquidations falling this could change. 6. Distribute it to Shareholders When a retirement company, or a company set up to make investments, is created it can have different shareholders to your main contracting company. This can mean that with careful planning (and you still need to consider settlements legislation please refer back to our Dividends ebrief) dividends can be paid to family members who are shareholders. We are serious, be careful you need proper advice, but it can be done! 9

10 Capital Gains Tax and Protecting Investments Before you consider implementing any of these specific strategies, you will need to understand a bit of background about Capital Gains Tax within companies, the possible side-effects of substantial non-trading income, and circumstances when it may even be appropriate to take the cash out and invest personally. Also if you are building wealth in a limited company the first priority (and duty of all directors) is to safeguard the assets of the business using protection and risk control policies. Protecting Investments or surplus funds and ring fencing Operating as a contractor is generally considered to carry low commercial risk, but you should always be aware of: 1. Any uninsured business risks for negligence - avoidable by taking out adequate professional indemnity insurance, and 2. Claims made under IR35 by HM Revenue & Customs (HMRC) - a measurable risk with the help of a specialist contractor accountant. 10

11 If you believe these risks remain in your business, you should consider protecting your retained profits, and any subsequent investments that are made with the money. This can be achieved in various ways, but a common solution involves creating a separate company (owned by you) that holds a special class of shares in your main company. Surplus income could be declared as a dividend to the new company via the special shares. The new company does not have to pay tax on the dividends received and, once received, the funds belong to the new company. Generally, the money held by the new company is then free of any commercial risk that existed in your contracting company. Caution and advice is recommended and the overall value of the investments being protected needs to be sufficient to make the extra effort worthwhile. The downside of course is that this new company may be subject to a slightly higher corporation tax rate, but not always, so it s worth discussing the tax regime that would apply in your circumstances. Capital gains made in a company Firstly, companies don t pay Capital Gains Tax they pay corporation tax on capital gains. Capital Gains Tax for individuals varies between 10% and 28%, whereas small companies pay corporation tax on capital gains at 20%. Secondly, companies don t get the same annual Capital Gains Tax free allowance available to individuals. There are also other more specialist tax reliefs that are not available to companies that we don t need to worry about here. 11

12 Non-trading income A company whose activities are considered wholly or mainly non-trading because it s income does not come directly from an active trade of being a freelancer or contractor, is treated differently and does not enjoy the small companies rate of corporation tax. In these circumstances, income and gains are taxed at the full company rate, currently 20%. Non-trading income is often found where the income or gains are entirely generated passively. However, as you would expect with anything connected to tax, it s never that simple and what is trading to one person or company may not be trading to another, so it s always worth seeking advice based upon the circumstances that apply to you. Companies don t pay Capital Gains Tax they pay corporation tax on capital gains. Capital Gains Tax for individuals varies between 10% and 28%, whereas small companies pay corporation tax on capital gains at 20%. Extracting excess money from the company and investing personally It s long been established that dividends are more tax efficient than salary when taking money from your company, because they avoid national insurance. Where a dividend is received and you are a higher rate or additional rate taxpayer, you are assessed to and required to pay further income tax personally out of the cash received, or other personal cash resources. This tax liability reduces the amount you receive and what is available for you to invest. 12

13 Limited company surplus cash In conclusion If you are one of the lucky ones, and having created surplus income, want to start investing that cash, then there are many points to consider: If it really represents spare income, then don t pay more tax on it than you need to. If you want to make a specific investment, then speak with your IFA first. And, if you don t have an independent adviser, then make sure you get one. If it has to be a personal investment, perhaps borrow from the company, and if you intend to cease contracting soon-ish (not always upon retirement) check out your options now. Before making any decisions, speak to your contractor accountant who will advise you of your options. The contents of this ebrief, should not be considered advice in any form, and the illustrations and examples are provided for guidance in relation to surplus income only. References to investments illustrate our experiences of what contractors have done in the past. They are not a recommendation or endorsement, and should not be read as such. 13

14 The Perfect Mix of Team, Technology & Expertise for only 92+VAT per month Intouch Accounting are Limited Company Accountants who advise thousands of contractors and help many of them overcome issues with the taxman everyday. We have an experienced friendly team who can set up a company for you, manage your accounts and provide ongoing advice in relation to investing surplus cash. Reminders Know Where You Are Personal Tax returns must be filed online by 31 Jan to avoid penalties 34K 23K 11K 0 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar These figures reflect your accounts as at Directors Loan Account 0 Colin 11K Adviser 23K Owed to Colin 6,401 If you change your contract reconsider IR35 34K VAT VAT Tax payment reminder VAT Corp* Tax VAT Wages for July 2013 Colin Gross Wage 1,000 Adviser Consider Insurance protection in case you re too ill to work PAYE PAYE Profit/Loss for the year to date Less estimated company tax Less dividends declared this year Plus earlier year s profit PAYE Financials to July ,701 9,340 13,348-8,683 PAYE Maximum dividend payable 15,330 Sick Pay Parenting Pay Income Tax National Insurance Student Loan Net Wage As an Intouch Client you also get 24/7 access to our innovative Client Portal, which saves you time when managing expenses and invoices and lets you know where you stand at all times. Why not explore what becoming a Limited company contractor means for you? Give us a call on or visit and we can go through your circumstances and advise on what is best for you. 14

15 ebrief for freelancers and contractors At Intouch Accounting, we work with contractors every day, helping them to understand their options, make the right decisions for their businesses and save money. So speak to us about how we can help you reduce the administration burden. Client Enquiries: New Enquiries: Skype: Intouchaccounting Online: intouchaccounting.com Intouch Accounting Ltd, Everdene House, Deansleigh Road, Bournemouth, BH7 7DU Registered in England & Wales - Company No

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