SHARES OR LOANS? Why lending capital can be more tax efficient than buying shares?
Every startup needs working capital to grow, and there are several ways to get this… but which one is the best? As the founder or owner, you could provide capital by purchasing more shares or by simply lending your company the cash. This could offer a more speedy return on your investment, and make you more tax efficient at the same time.
- Is funding by buying shares not advisable?
Many people buy shares in order to provide more capital, and while there is nothing wrong with this, depending on your situation there may be other, more beneficial ways. One of the biggest disadvantages of buying shares is that you may need to wait a while for any Return on Investment (ROI). Your company can pay you dividends but only when it is making a profit and in the case a new startup business, it may take a while. There’s also no guarantee that you’ll see a return on your investment at all.
- What’s so great about funding by loaning capital?
If you’re looking for a faster ROI as many founders, then lending your company the money could be the way to go forward. Providing a loan means that you can be paid interest straight away, plus loans are generally more flexible than being paid dividends as you can receive some or all of your money back without being required to cancel share capital, which could significantly affect your tax. This leaves you with more control of your money, which as an investor, feels much safer.
- How can being married help?
If you happen to be married or in a civil partnership, then lending to your company could bring you even better tax advantages, so it’s worth exploring this avenue fully.
These tax advantages also work if you are unmarried with a “significant other”, however as a general rule, it’s much easier if you have combined finances through a lawful marriage or civil partnership.
This arrangement can help you save on tax if your partner pays a lower rate of tax than you do, as they can lend you money and charge you interest. You then lend the money to your company and charge the company a similar interest rate.
- How does this work?
Doing things this way requires that a) the interest is taxable, and b) any interest paid on qualifying loans that are used for company funds, the purchasing of equipment, or for working capital for a trading company are tax deductible.
Here’s an example that breaks this process down:
Joe is a director, shareholder and higher rate taxpayer of the Joe Bloggs Ltd., and the business requires some new equipment. Joe’s wife Jane is a basic tax payer, and so she makes an interest-free loan of £100,000 to Joe, who then lends this to his company Joe Bloggs Ltd., charging interest at 7% per annum.
Joe is liable for tax of £2,800 (£7,000 x 40%) on the interest he receives from Joe Bloggs Ltd. Joe doesn’t pay Jane any interest which means there is no tax relief for him to claim (though the loan to Joe Bloggs Ltd. does qualify).
Alternatively, if Jane decides to charge Joe the same rate that he charges Joe Bloggs Ltd. (7%) instead of an interest-free loan, then the interest Joe pays Jane will be tax deductible. This means the taxable interest (£7,000) he is paid by Joe Bloggs Ltd. equals the tax deductible interest he must pay to Jane. One cancels out the other, and instead of paying £2,800 in tax, Joe pays nothing.
Jane’s loan to Joe isn’t a qualifying loan, so she will have to pay tax on the interest she receives from him. Luckily, as Jane is a basic rate taxpayer, her bill is £1,400, meaning a tax saving of up to £1,400, and possibly much less depending on Jane’s other sources of income. As mentioned earlier, the advantage of doing things this way means that even if Joe Bloggs Ltd. is not making a profit at the moment, it can still pay Joe a return on his loan. This is often the best and most tax efficient way for company founders to provide capital to their business.
Want to find out more about how this could help make you more tax efficient? Get in touch with our team at Price & Accountants to discuss how we can help. We are committed to helping small businesses in London and around the UK with their accounting needs, using Xero online accounting software and our expert team of advisors, all dedicated to helping your business flourish.
Rahamut Bhuiyan (Author)View Post