With an ever-changing tax landscape to contend with, one of the biggest challenges most business owners face is extracting profits from their business without triggering an unwelcome personal tax bill.
Financial advisers play a crucial role in helping clients navigate these complexities, offering strategies to optimise income and minimise tax liabilities.
It’s a widely accepted practice for limited company owners to pay themselves a salary up to the tax-free personal allowance and then top up the rest of their income with dividends. But this approach is less effective than it once was.
When the dividend allowance was introduced in 2016, the first £5,000 of annual dividend income received was tax-free. However, this allowance was lowered to £2,000 in the 2018/2019 tax year, cut again to £1,000 in the 2023/2024 tax year and halved yet again for 2024/25 – meaning only the first £500 of dividend income received is free from tax.
Case study
Let’s consider a typical scenario of a business-owning client. Raj is a design consultant with his own limited company. To be tax-efficient, he pays himself a salary up to the tax-free personal allowance of £12,570 and tops up his income with an annual dividend of £50,000. However, he is aware his tax bill resulting from this annual dividend is less than ideal.
For the 2024/25 tax year, Raj can only claim a £500 tax-free allowance on the dividend he pays himself. The next £37,200 is taxed at 8.75%, and the remaining £12,300 is taxed at 33.75%. This leaves Raj with an income tax bill of £7,406. As a result, withdrawing £62,570 from his limited company annually leaves him with just £55,163 after tax.
Raj discusses his situation with his adviser, who explores the benefits and risks of investing in a venture capital trust (VCT). His adviser informs him that if he invested £24,687 in a VCT, he could claim 30% income tax relief on his investment, which equates to £7,406, provided those VCT shares are held for the minimum five-year holding period.
VCTs often target a free dividend, so Raj can expect to receive an annual tax-free income from his investment. VCT dividends are completely tax-free, and there’s no requirement for Raj to declare them on his tax returns. By investing in a VCT, Raj effectively wipes out his income tax liability, giving him an annual income of £62,570, plus the potential for tax-free dividends from his VCT investment.
Huge opportunity
Given there are 5.5 million small businesses (with 0 to 49 employees) operating in the UK, representing 99.2% of the total UK business population, this clearly represents an enormous financial planning opportunity for advisers to tap into.
Importantly, when it comes to recommending VCTs to business owners, the job of bringing these investments to life for some of the highest-value clients is relatively straightforward.
Business owners are often very willing to consider investing in a VCT because, when it comes to the challenges smaller companies face and the thin lines between success and failure, they instinctively ‘get it’.
Business owners know better than anyone why smaller businesses need access to capital and investing in VCTs means they get to support the UK’s entrepreneurial ecosystem and do their bit in funding their success.
Of course, helping business owners to withdraw profits from the business tax efficiently is just one example of how a VCT can solve different clients’ planning challenges. With changes from the recent Budget, the adviser’s role in guiding clients through the financial planning landscape has become more important than ever.
Diana French is retail strategy director at Triple Point
This is all very well, but VCT’s invest in very small companies and the risk of them failing is high. A well worn mantra is Don’t let the tax tail wag the investment dog.
Absolutely Julian.
I always refer to VCTs as Void Capital Totally. As you say a prime example of the tax tail wagging the investment dog.
What about Raj employing his wife (and ensuring proof of work). This then doubles the TF allowance and if she has shares she too can take dividends up to the max tax free.
Perhaps if possible (not enough info in the example) he could un incorporate and become self employed. Immediately there is more scope for tax allowed expenses. If he needs employees, take them on as LOSC – hence no NI.
Best solution? Emigrate.
Some nonsense being spouted by Julian.
“VCTs invest in very small companies” – If you knew your stuff, you would know that most VCTs invest in companies which have a turnover of at least c£1 million, typically in the region of c£3-5million.
“The risk of them failing is high” – Again, not true. All you need to do is look at the past performance for VCTs.
VCTs have a place for certain clients, primarily those who are earning well in excess of £260,000 per annum, where their ability to contribute into a pension is non-existent.
The 30% tax relief and tax-free dividends can be a very effective planning strategy.
Just because you don’t have the right clients for VCTs, doesn’t make them a bad strategy.
After some of the VCT guys conversations I’ve overheard in the world of co-working in London, I’ve affectionately renamed them Vulture Capital
Phew! Let’s hope Raj has £25k in savings after paying his mortgage, losing some of his child benefit and having to pay nursery fees for his two young children…
Hope he doesn’t live in London!
Excellent Diana, useful information on a different slant on tax benefits if VCT