Extracting your profits from your limited company in the most tax efficient manner continues to be an issue and a perennial question for accountants and, as with many areas of tax, gets more complicated as time passes. Part of the problem lies in the increasing numbers of business owners and contractors utilizing limited companies as trading vehicles, given the much-vaunted tax advantages of incorporation (turning your sole trader or partnership business into a limited company) and bigger businesses trying to avoid their liabilities by taking on self-employed contractors rather than employees.
As we all know, National Insurance is expensive and no matter what you call it, is just another tax so not surprisingly, it’s very popular to extract as much profit as possible via dividends, after of course paying the minimum possible salary while still qualifying for entitlement for the state pension. This is an excellent strategy because it’s not actually necessary to pay any National Insurance whatsoever despite building up a successful contribution record which counts towards state pension.
In addition, from the tax point of view, given the availability of the current generous personal allowance (which exempts the first £11,000 of your income from tax) extracting your profits by dividends has meant that, even for a sole-shareholder, profits of over £43,000 could be extracted from a limited company without any personal tax arising whatsoever!
It wouldn’t surprise you to learn that HMRC are not keen on small businesses extracting profits by dividend and thereby avoiding National Insurance contributions and personal tax. Thus, they have tried many times over the years to limit the use of dividends including such strategies as the well-known IR 35 rules, various court cases, increasing small companies’ Corporation tax, having a go at umbrella companies in addition to introducing various complex legislations to counter what they regard as tax avoidance.
However, despite their best efforts profit extraction by dividend has remained stubbornly popular and only now are the consequences of the new dividend taxation arrangements (which came into effect on 1st April 2016) becoming clearer, as accountants complete their client’s tax returns for the 2015-2016 tax year and submit these to HMRC. Under the new rules, the 10% free tax credit added to dividends in the past (which basically
pays the basic rate tax for you) has been phased out and instead, they have introduced a new zero rate tax band for dividend income. Unfortunately, the zero-rate tax band for dividend income has been set at a miserly low level (surprise, surprise!) at a mere £5,000. What this means is that previously tax-free dividends will now be taxed when your combined personal income i.e. including your salary allocated for National Insurance contribution purposes exceeds approx. £16,000. What’s more, HMRC are trying to collect the tax early by adjusting taxpayers PAYE codes by an assumed level of dividend income based upon prior years!
Does this mean that the popularity of dividends will suddenly wane? Well not necessarily, because a new opportunity has arisen! Under the historic rules there was no point in making your spouse or partner (or adult children) shareholders and allocating them a share of the profits unless they were unwaged or enjoyed very little income. However, under the new rules even higher rate taxpayers can receive up to £5,000 worth of dividend income from your business completely tax free, saving a decent amount of tax!
So as always with tax it is necessary to be fully aware of the rules and work through your own situation with your accountant. Talk to us about your personal circumstances, we will be able to advise you of the best approach.