How to reduce your 2014 tax bill in 10 simple steps
Contractors often get the wrong idea about tax-planning. They see it as a last-minute way to deduct as much as possible from their tax bill and hope they “get away with it”. With that strategic battle plan, they very often don't!
The key to tax efficiency is to implement a year-round strategy, planned from Day 1. And, of course, making sure it’s all legal and above board.
Contractors and company directors benefit in two key areas by implementing this modus operandi:
- attain Zen-like peace of mind, knowing that they've created their strategy within HMRC guidelines;
- their business is so lean, it maximises each tax-saving opportunity as it arises during their fiscal year.
This guide will look at both of those aspects, running a day-to-day business and investing in your future. Moreover, it will outline how you can adopt those tenets to start making the most of the tax relief on offer from HM Government.
Day-to-day optimisation of a well-honed tax-planning strategy
One of the great things about having a plan and sticking to it is that regular practice becomes habit. If you strive to optimise the day-to-day running of your business, its future has a great platform upon which to build.
Start each day the green way
There was a time when “owning” a company car had benefits. They’re long gone, but you can do your bit for the environment and your bottom line by lowering your CO2 emissions.
The lower your car’s emissions, the less the percentage of tax your business will incur.
The thought of electric cars was as, at one stage, as far-fetched as the thought that company cars would become a liability.
Yet great strides in electric travel makes this option both feasible and a boon to your company. Zero-emission vehicles attract zero percent, so they’ll cost you nothing in liability.
Capital expenditure remains 100% deductible, to a point
January 2014 marks the half-way point of a two year government initiative. It allows many business types to use up to £25,000 of their AIA as a mechanism to claim capital allowances.
There are some caveats, as you'd expect. This relief is only available on the first £25,000 of investment in plant and machinery.
It’s also only in place until December 31st, 2014. And finally, company cars aren't included in this expenditure relief program.
Maximising your household’s personal allowance
The absolute majority of people think that personal allowance is just that: personal. However, if you’re married or in a relationship you can, for all intents and purposes, share the joint allowance.
What this means is that those whose partner has little or no income, in effect, can transfer their allowance to the other.
Again, there are caveats for doing this.
For example, you, as the bread-winner, transfer x amount of your income to your spouse. The transfer must represent an out-and-out gift.
Once gifted, they can then claim their personal allowance against the amount you’ve transferred.
Where you’re both living under the same roof, you share the status of “tenants in common”. This means you can transfer your income into joint names, if you can’t or don’t want to transfer it 100% to your partner’s name.
As long as you pay your partner interest, even if it’s a penny in the pound, both parties can claim allowance on the income.
There are laws for income shifting, so you may be best to discuss your circumstance with your accountant. They'll tell you the best way to manage income transference for you and your business.
Are you an “empty-nester”? Put your free space to use
As our children mature and set out on their own, can we honestly say we do anything useful with the rooms they vacate?
If you’re comfortable with lodgers, you earn income in two ways. First, from their rent direct. But it's not all subject to tax if your salary swallows your personal allowance.
Under the “rent a room” initiative, up to £4,250 of their rent attains tax-free status.
You will have to half that threshold if you’re implementing any shared income privileges. But if your lodgers co-habit as part of the larger family, capital gains exemption remains 100% unaffected.
Separate laws do apply if you convert your home for the specific purpose of earning rent. Also, the rooms you let must be fully furnished, whether the lodger occupies a single room or an entire storey of your property.
Capitals Gains exemptions
In the same way that you can transfer personal allowance to your partner, you may also have the opportunity to transfer assets.
It's simple, too. Keeping tenure in joint names prior to a sale will help you utilise the full CGT exemption limit.
It’s also worth noting that you don't have to realise any large gains in one fiscal year. To help make use of more than one year’s CGT exemption, you can carry a large gain over into next year’s accounts.
The downside is that should you keep making large gains, there comes a time when you have to bite the bullet and pay the taxes due. I know. It's a hard life.
So, if the gain is from commodities increasing in value, keep your eye on them. You don’t want to lose that gain for the sake of holding out on the tax man!
Using tax relief to secure your future
Once you’ve stream-lined day-to-day aspects of business, your thoughts can turn towards the future.
There are countless incentives for limited company contractors to save. Many of them leverage tax relief to ease the financial pressure of investing.
Is it time to become a limited entity?
By far the most tax-efficient way for contractors to operate is by becoming a director of their own limited company. And there are specialist accountants who can help make that leap of faith a breeze.
But many new to contracting opt for the sole trader or umbrella company route whilst they come to terms with their new lifestyle. There is, in theory at least, less to think about this way.
When your next year-end approaches, it’s worth reviewing your own trading mechanism. Assess and test whether it’s the right time to form a limited company of your own.
All but in an exceptional few circumstances, contractors are far better off as a limited entity than remaining not so.
First, there are the many (many) more tax breaks you could avail yourself of. Also, stepping up from sole trader to limited company contractor separates you from your debt.
Another aspect to consider is the perceived professional status that having “Ltd.” after your business name transposes.
A contractor-friendly accountant will help you form and register your company. But do choose one with bespoke experience in contracting.
Your unique circumstances will play a part in how your company is born. There are off-the-shelf packages, but they're often too basic or come with clutter you just don't need.
Contributing to your pension fund through your business
Pension schemes remain one of the greatest single sources of tax relief for limited company directors.
Paid through your company, the contributions qualify for tax relief. You can also match whatever you earn up to £40,000 (as of April 2014 – currently £50,000) of relevant earnings in any given fiscal year.
Those newer to contracting may not quite have reached that earning potential. Don't worry. You won’t necessarily lose the bigger opportunity.
You have three years to carry over any unused personal allowance from a given tax year. It’s worth remembering, as when you do start to qualify for higher rate tax, the net effect of relief can equate to a 45% saving.
The only cloud on the horizon for contractor pensions is the lifetime contribution allowance. Whilst the maximum one can pay in over their working life currently stands at one and a half million pounds, that’s set to drop in April 2014.
From thereon in, the maximum anyone can pay into their pension fund will be £1.25M over your lifetime. Again, the hard luck story plucks at our heart strings.
Seriously, some higher-rate tax payers contribute the full permissible amount year in, year out. With this reduction, they’ll obviously reach their lifetime limit a lot sooner than they thought.
Sensible investment: stay fluid with an ISA
One of the greatest benefits of contracting is the potential increase in disposable income for doing the same job.
That's 'the same job' compared to a permanent employee, at least. We're not suggesting you leave work then return as a contractor. Not unless you want an IR35 team beating down your door.
What you shouldn’t get into the habit of is thinking that the surplus you earn and keep is cash on your hip. A handy way to move the cash out of harm's way is by opening an ISA.
There are three main benefits of ISAs to contractors, especially those new to the lifestyle:
- ISAs, as a rule, return greater interest than a standard savings account;
- you can still transfer money to an expense account instantly to cover unforeseen expenditure;
- however, ISAs are most beneficial when left untouched;
- the maximum anyone can pay into an ISA in a given year, for 2014/15 set at £15,000*, can be all cash or cash, stocks, shares and dividends;
- the latter is perfect for contractors who draw their limited company income as a combination of both salary and dividend.
*As of July 1st, the government increased the threshold on adult ISAs. Any adult can take out one Cash ISA or one Cash, Stocks and Shares ISA per annum.
The limit for either is £15,000. You cannot take out one of both. A married couple, however, can, giving them a household maximum of £30k per annum.
The Cash ISA is self-explanatory - £15k cash savings a year is the maximum tax-free threshold. Into a Cash, Stocks and Shares ISA, you can deposit dividends, stocks, cash or any combination thereof .
Any interest you earn is tax-free; also, any ISA investiture is free from Capital Gains Tax. For those new to contracting, an ISA is the perfect vehicle to start building for their future in a tax-efficient manner.
Inheritance tax is not only for your legacy estate
When we think of IHT, it’s always in the past tense. But in a very real sense, IHT is the gift that keeps on giving.
In any given fiscal year, as a company director you can gift a up to £3,000 (assets or cash) before tax. That's besides gifts from net pay, which are also IHT-exempt. Well, they are so long as your benevolence doesn’t negatively impact your contractor lifestyle.
As with most tax-planning, there are caveats. IHT is no different, but for this one you’ll be thankful. You must survive the gifts you make for seven years before they escape the Revenue’s clutches.
Until those seven years have passed from you gifting through your company, their value is in a sort of financial limbo. Otherwise known as PETs.
Should you die within that seven year grace period, the value of the gift is transferred out of the PET and added back to your estate.
But only gifts made in the two years before your demise are subject to full IHT. Any gifts made from those two years up to the tax exemption date and above the upper gift limit have tax discounted at a generous 80%.
Finally for company tax relief, where there’s a will, there’s a way
There' no legal requirement for anyone to write a will. But where a contractor has built up assets they'll want to bequest in a specific matter, it’s advisable.
It's even more important if either you (the estate holder) or the beneficiary has cash/assets worth more than the upper IHT threshold when you die.
For large estates, if a will isn’t drafted in a tax-efficient manner, Inheritance Tax can greatly erode its value.
But that’s not the only concern: you must specify the distribution of your estate. If you don't, there’s always the potential for unrest amongst potential beneficiaries.
If you have no will, your estate will also have to work its way through the revenue and its myriad calculations. During this time, the cash and assets you leave is bound over.
Any delay could be critical to your survivors if you were the sole source of income for them. Where there's a will, there's a way. And it's a lot more direct than through HMRC's dusty corridors!
So. We've given you ten practicable tax-planning measures for 2014. Five of them you can factor into your day-to-day business almost immediately. The other half are there for the long-term prosperity of you, your business and your family.
We hope to have cleared up some of the misconceptions surrounding more common tax strategies for you. Also, that we've opened your eyes to tactics you’d not considered.
These are by no means the only way contractors can reduce their tax liability. Our guides resource has many other niche-specific articles in this vein. We hope this one helps you form tax efficient habits today for a more profitable, sustainable tomorrow.
John Yerou is a pioneer of contractor mortgages and owner and founder of Freelancer Financials, Contractor Mortgages®, C&F Mortgages and Self Employed Mortgages, trading styles and brands of the award-winning Mortgage Quest Ltd.