Building up a pot of cash in a contractor limited company could lead to an unexpected and unpleasant tax bill, until the main and small companies corporation tax rates equalise. Contractors have traditionally considered one of the benefits of the contracting lifestyle to be periods of high earnings interspersed with long breaks. As a result, many high-earning contractors actively accumulate large balances of cash and other financial assets in their contractor limited companies.
But James Abbott of contractor accountant Abbott Moore LLP warns that this could leave contractors paying more tax than they expected. “Contractors with large cash balances and financial investments in their company can fall foul of Close Investment Company (CIC) rules and see their corporation tax increase to 23%,” explains Abbott. “And those who also take long breaks from contracting run the risk of their limited company being classified as investment companies by HMRC, with correspondingly higher tax bills.”
CIC rules will, eventually, apply
According to Abbott, a common scenario for many contractors is to decide to work non-stop on high value contracts for five years and pay themselves tax efficiently during this period, by withdrawing a minimum salary and dividend.
“As a result of this strategy, the contractor accumulates in the limited company several hundreds of thousands of pounds in retained profits, typically held in cash and investments,” continues Abbott. “After five years, the contractor’s plan is to stop working but continue to pay themselves tax efficiently for, say, the next five years via minimum salary and dividend.”
Abbot explains: “The company will be treated as being a CIC from the date the company ceases its freelancing trade and will be liable for 23% corporation tax on its taxable income and gains going forward. The contractor can still continue to pay themselves a minimum salary, but the tax efficient dividend will be reduced as retained profits are paid out and ongoing profits from investments shrink, and attract the higher rate of corporation tax.
"Fortunately for contractors, as the small profits rate of corporation tax, currently at 20% and the main rate of corporation tax, currently at 23% converge, as is the government's intention, there will be no increase in corporation tax once a contrcator's limited company becomes a close investment company. However, the other issues relating to CICs will remain."
Three years grace… if you’re not going to trade again
However, contractors with cash in their company and who wish to take their payout within three years or fewer might find they can still obtain Entrepreneur's Relief (ER). Abbot explains: “When a business has ceased trading, there is usually a period of ‘grace’ allowed by HMRC for the owners to wind up the business for ER purposes.
“So whilst the company may have ceased the freelancing business and become a CIC from that date onwards, contractors could withdraw their cash over three years with the added bonus being able to claim Entrepreneurs’ Relief under an application under Section 1030A when the company is wound up.” He continues: “The important point is that the company must not have been a CIC or broken the 20% rules in the 12 month period prior to ceasing the freelancing trade.”
Paying a minimum salary and dividends at the lower rate of tax over 36 months and applying for Entrepreneurs’ Relief to distribute any remaining capital at 10% would still be tax efficient. This strategy could net contractors more cash than paying higher rate tax on dividends.
‘Intention’ is key when taking a break
Contractors who wish to take extended breaks from contracting should also be wary of how much time they take off and the way in which they take a holiday. Abbott explains: “The contractor’s intentions are key to how HMRC will treat their tax status and the status of their limited company.
“If a contractor takes a fortnight off for a summer holiday, even though technically the contractor is not trading nor available for work, the contractor is clearly still in trade and fully intends to resume trading on their return from holiday.”
However, contractors who take 2 years off to backpack around Asia may find it difficult to argue that they have continued trading during this period and possibly in the future. Abbott says: “If there is no obvious intention or ability to trade, and the contractor is not looking for work or available if it was offered, this means any assets and income in their limited company are non-trading and could be subject to 23% tax under CIC rules.”
Contractors taking an enforced break because they can’t find work shouldn’t be affected by CIC rules. Abbot explains: “If a contractor is not working for six months because they can’t find work, but are clearly and actively seeking a contract on behalf of the company, then they can live off accumulated cash in the business, pay a salary and, assuming there are sufficient profits, also pay a dividend during the time they can’t find work.”
The contractor's intentions are key to how HMRC will treat their tax status and the status of their limited company
James Abbott, Abbott Moore LLP
Running a CIC – allowable salary and costs?
Contractors who choose to accumulate large cash balances and investments in their contractor limited company and accept taking the hit of 23% corporation tax as part of the CIC status, can still pay themselves tax efficiently.
“A contractor can pay themselves a reasonable salary for managing a CIC, plus reasonable expenses. They can also draw a dividend if there are reserves, or profits,” continues Abbott. “Attendance at an investment seminar, a new computer with software and accountancy bills are all reasonable expenses.”
Even a spouse actively working in the business could claim a salary, but their work would need to be justified Abbott says: “A minimum salary of, say £5,700 works out at around 75 hours per month on a minimum wage. Could the contractor’s spouse evidence this amount of time spent on the business?”
Abbott concludes: “As ever, when it comes to making business decisions that could affect their limited company’s tax status, contractors would be well advised to take professional advice if they’re not 100% certain of the latest tax rules.”