Is dividend still best for small business owners?

Back in 2016 George Osborne changed the way dividend income is taxed! This is a significant change to how small business owners takes income from their Personal Service Companies.

The taxation of dividends changed from 6 April 2016 through the fanfare of removing many from paying tax on dividends. The reality for business owners of limited companies is anything but and it now appears that they are paying the price for the Government’s commitment to reducing the main rate of corporation tax.

Changes from April 2016:

  • the dividend tax credit was repealed. This has been a major change on small company owners, moving the tax liability from the company to the individual shareholder / director.

  • a new dividend allowance of £5,000 per year was introduced (this does not reduce total income, but essentially taxes the first £5,000 at a 0% rate, so reduces the basic and higher rate bands). This will be reduced to £2,000 from 2018/19, and

  • the rates of tax on dividend income will increase to 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers with taxable income after personal allowances over £100,000.

Profit extraction cost

The observant amongst you will know that the answer to the perpetual ‘salary versus dividend’ question asked by clients has generally always been that dividends are best from a tax perspective. Notably this is because no national insurance liability accrues on dividends, though of course sufficient distributable profits must be available in order to ensure that a legal dividend can be declared and paid.

The Chancellor is closing the tax gap between extraction of profits by way of salary or dividends. The following analysis is based on current announcements including that the NIC upper earnings/ profits limit increases to £45,032 (for Class 1 and 4 NIC 2017/18) and that the owner / manager extracts a salary of £8,164 (the employers NIC threshold 2017/18), with the remainder taken as dividends.

There is still a small tax benefit in operating as a limited company as opposed to a sole trader though this disappears around profits of £140,000. On average, up to £200,000 of profits, the marginal effective tax rate benefit on extracting profits from a company as compared to operating as a sole trade will now only be around 1.4%. 

Dividends as the ‘top slice’ of income

For those receiving dividend income, it is always important to consider the tax impact of dividends being the ‘top slice of income’. If we just look at the marginal rates on paying a dividend, the cost has increased by 7.5%:

For owner/managers extracting profit using low salary and dividends utilising their basic rate band, there is an immediate cost once dividends paid exceed the £5,000 allowance.

Consideration will also need to be given where taxpayers are close to the higher or additional rate thresholds as the dividend allowance, whilst tax free, will push income into higher marginal rates. The following table shows the additional tax cost where £5,000 of dividend income is pushed into the next marginal rate of tax:

Dividend income taxed at:

£

Higher rate (£5,000 x (32.5% — 7.5%)

1,250

Additional rate (£5,000 x (38.1% — 32.5%)

280

Therefore it may be worthwhile deferring payments or ensuring all options have been explored to extract profits in a tax efficient manner.

What can you do?

  • bringing forward the payment of dividends into 2017/18 to take advantage of the £5,000 annual dividend allowance, before it is reduced to £2,000.

  • Use the directors’ loan account, but this will involve an advanced corporation charge on overdrawn balances (32.5% corporation tax charge) with the advanced tax payment only being recoverable when the overdrawn balance is repaid.

  • maximising tax efficient profit extraction, eg pension contributions and other tax free benefits

Comment from the Helpful Bean Counter

This has had a significant impact on many of our business owners. Beware of the change to the Directors Loan Account, the advance corporation tax payment will hit your cash flow. Please contact us on info@freelanceus.co.uk if you want to discuss your situation? 

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