Will you pay 72% effective tax as a business owner?

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The UK tax system is notoriously complex – often leading to honest taxpayers making mistakes which cost them later. One example of this is that certain business owners may end up paying as much as 72p on every £1 they earn in their lifetime.

This can occur when 40% inheritance tax (IHT) is added to the value of assets which have already been taxed over a taxpayer’s lifetime (due to income tax and National Insurance). Below, we explain why this can happen and offer ideas about how to avoid it.

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How do some people end up paying 72% tax?

Many people in the UK go throughout their lifetimes without giving much serious thought to inheritance tax (IHT). Yet it can be a highly punitive tax if you are not careful, levied at 40% on an individual’s estate once it crosses the £325,000 IHT-free threshold.

However, the effective tax on assets over this limit is even higher when you consider how they may have already been taxed over the individual’s lifetime. Perhaps they have been subject to income tax, capital gains tax and/or dividend tax. Then, at the owner’s passing, there is a death duty! This is partly why IHT is the UK’s most “hated levy”.

Business owners, unfortunately, can be particularly badly hit. According to research by RSM, certain business owners may end up paying £72 in tax on each £100 earned through their company. This assumes that they paid:

Income tax
Employees’ National Insurance Contributions (NICs).
Employers’ NICs.
Class 4 NICs on cash coming into the IHT “net”.

This dynamic – i.e. multiple rounds of taxation eroding the wealth of Britain’s job creators (business owners) – has previously been highlighted in a report called The Single Income Tax, by the 2020 Tax Commission.

In the report, the authors call for the abolition of IHT – along with seven other taxes – which are seen as unfair. Yet with IHT receipts in June 2023 standing at an all-time time (£795 million), it seems unlikely that the government will enact this any time soon.

Instead, business owners need to take control of their own tax plans to minimise needless wealth erosion. Below, we share some ideas on how to achieve this.

Tax-efficient planning for business owners

Minimising a needless tax bill involves two main strategies – an immediate tax plan and an inheritance tax (IHT) plan. The former focuses on mitigating tax at the time when income or assets are acquired. The latter prepares these for eventual passage to your beneficiaries in an IHT-efficient manner.

For their immediate tax plan, in 2023-24 company directors arguably face a more complex tax landscape than those who are solely employees. Yet they can also leverage a wider range of tax planning tools. Some ideas include:

Managing income sources efficiently. In particular, directors can receive both a salary and dividends from their company. The latter is taxed at lower rates compared to the former, which can create opportunities to lower a director’s tax bill.
Using allowances. In 2023-24, dividends are tax-free for a UK resident up to £1,000. Also, capital gains are tax-free up to £6,00 per year. Many taxpayers can also receive up to £12,570 from earnings without income tax (although a taper applies after £100,000).
Leveraging ISAs. Up to £20,000 can be put into an individual’s ISAs each tax year. Any dividends, interest or capital gains generated from the contained assets are tax-free.
Planning with your spouse or civil partner. Both you and your partner are entitled to your own tax-free allowances (mentioned above). You might be able to save on your household’s overall tax bill by re-organising your assets.
Using tax-efficient investment vehicles. For instance, the Enterprise Investment Scheme (EIS) lets an investor claim up to 30% income tax relief on the value of EIS investments.

Strategies like these can help a business owner mitigate taxes during their lifetime. At their passing, moreover, an effective estate plan can help them leave a more meaningful legacy to their loved ones. For example:

Using the Resident Nil Rate band (RNRB). This lets someone pass down an extra £175,000 to their “direct descendants” if their estate includes the family home.
Using gifts. Each tax year, an individual can give away up to £3,000 without these getting counted as part of their estate for IHT purposes.
Using Business Relief. This grants either 50% or 100% IHT relief on certain business assets either during the owner’s lifetime or upon death.
Using EIS and SEIS. These schemes allow an investor to exempt their EIS or SEIS shares from inheritance tax if they are held for a minimum period.