For most entrepreneurs, and especially startup owners, your personal financial well-being tends to be closely entwined with that of your business. Investing in your business is a necessity for it to flourish and, more importantly, for it to generate a profit from which you will benefit.
Simply put, you want to be able to put money in, and ultimately take the profits out. Ideally, without either you or your business taking an unnecessary hit when it comes to tax. Potential financial backers looking to invest in the most tax-efficient route will also expect your business to be structured in a certain way. Understanding investment tax can help you with all of this.
Here, we’ll outline the investment tax essentials, explaining what small business owners and potential investors need to be aware of.
Investing in your business as a sole trader
If you are a sole trader (or part of a partnership), there is no legal distinction between you and your business. For tax purposes, you are treated as one and the same thing. You are personally liable for income tax on business profits.
As a sole trader, if you were to transfer money from your personal account to your business account to cover startup costs, you are not investing in a separate entity. But of course, investment is as important for a sole trader as it is for any other type of business.
Larger items you invest in for your business to operate and grow, such as machinery and vehicles, are known as ‘capital assets’. Under the current capital allowances rules, you can invest up to £200,000 per year in most types of capital assets for your business and qualify for tax relief on them. If, for instance, you spend £10,000 on new machinery for your firm and your taxable profit for the year is £50,000, you need only pay income tax on £40,000.
Investing in your own company through a director’s loan
A company is a distinct legal entity. This means that when you or anyone else invests in a company, they are effectively transferring money to a separate legal ‘person’. Companies have their own tax, levied on profits, which is currently set at a rate of 20%. As the director of your own company, there are two possible ways to invest. A director’s loan or through the purchase of shares.
Benefits of a director’s loan
With a director’s loan (as the name suggests), you are essentially lending your company money. As such, this can be a useful and relatively straightforward way for a small business owner to boost company funds.
You should, however, ensure that your company’s ‘Articles of Association’ specifically allow the company to borrow money from directors. You should also check for any conditions or restrictions on such loans.
As such, it’s worth speaking to a small business accountant before you set up a loan. This is to make sure you get the formalities right. This includes ensuring that the loan is documented correctly on the company’s accounts.
Things to think about
A director’s loan is not classed as company income. Therefore the company is not liable for corporation tax on it. It is possible to charge the company interest on the loa. This is providing provision is made for this in the loan agreement.
Before the interest is paid back to you, the company must deduct income tax from the interest at the basic rate of 20% each quarter. Income from interest on a director’s loan is classed as income for income tax purposes. Therefore, this should be on your personal tax return.
Investing in your own company (or somebody else’s) through shares
A ‘share’ is a divided up unit of the value of a company. Both for small business owners looking to financially support their own company, as well as for investing in other companies, purchasing shares is the most common way of doing it.
You can invest in your own company by issuing shares in exchange for cash when you form your company, or throughout the company’s lifespan. You can read more about this in our Guide to Shares.
What are dividends?
Dividends are paid from profits (and after payment of corporation tax) by companies to their shareholders. As a director and shareholder of your own company, you have the option of splitting your income from the business between a small salary and dividends. Whether this is the best thing to do from a tax point of view depends on a number of factors. These include the level of profits your company is generating and your level of income from other sources.
This tax year (2016/17), the government introduced a new income tax dividend allowance of £5,000. This is separate from the standard personal allowance of £11,000. So even if your income from other sources means you are a higher rate taxpayer, if you have dividend income of up to £5,000, you will not pay income tax on this income.
Always seek independent financial advice before making investment decisions. In the meantime, head to our help centre for further tips on how to make your business ‘investor friendly’.