When the dividends don’t work

Most owner/directors of private limited companies will choose to pay themselves with a mix of salary and dividends.

Usually the most optimal set up is to pay themselves a salary up to the National Insurance Primary Threshold and top up the rest of their income as dividend.

In the current tax year (1920/21) that would mean drawing an annual salary of £9,500. Drawing a dividend of £40,500 in addition to the salary would give a gross income of £50,000. The income tax due on this would be only £2,287. No employee National Insurance would be due but a salary at this level would count as a qualifying year towards State Pension eligibility.

In comparison, personal income tax and employee National Insurance contributions on a £50,000 salary would be £12,358. Some £10,000 higher than the combined salary/dividend option.

The tax saving is much reduced if the combined company and personal tax impact are considered. Dividends are paid after corporation tax (unlike salaries they are not a tax deductible expense) so every £100 of dividend paid instead of salary incurs an extra £19 corporation tax. The company would also pay employers' National Insurance on salary above £8,632 per annum.

Nevertheless, for modest incomes, if looking purely on the basis of tax efficiency the combined salary/dividend option works best and most accountants will recommend this route.

So why wouldn’t an owner/director always choose this option?

There are a some cases where I think the salary/dividend route may not be the best choice:

    1. Where there are a number of senior managers who may not be shareholders

Where there are a number of senior managers who are not shareholders there might be a case for the owner drawing a ‘market rate’ salary for the contribution they make and topping up with dividends if profits are sufficient to allow this. This enables the owner to be transparent about profitability and remuneration with their senior management team. They might also combine this approach with a profit-based bonus scheme. The benefits may outweigh the tax savings gained from the salary/dividend remuneration method.

    2. Where an owner is preparing for exit

As above a ‘market rate’ salary reflecting the owner’s true contribution to the business might be a sensible transition in the years before they exit the business. The remuneration can be easily flexed if they gradually reduce their involvement. As with 1 above a top up dividend can be drawn on top of the salary if profits allow. This can be an added incentive for a business owner to drive the business to generate ‘surplus’ profits after allowing for their management contribution. In this way the business may be more likely to become a standalone investment rather than a lifestyle business.

    3. Where there are several shareholders with varying levels of input

Using salary rather than dividend in this case allows greater flexibility. As with 1 and 2 above dividends can be used as a ‘top up’ on the salary where all the shareholders benefit in proportion to their respective shareholdings.

There’s a saying in tax circles, ‘Don’t let the tax tail, wag the business dog’. 

I think it can apply here. 

It's not conventional wisdom for an accountant to say this but, in some cases, less tangible, business and operational considerations may sometimes override harder tax savings.

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8 things to do before the end of the tax year

It may not feel like it with the UK in the grip of snow and ice but we have already had the first day of Spring and the end of the tax year will soon be upon us. 

A little time spent planning in these last few weeks before the end of the tax year could provide useful savings. The tax year end for individuals is 5 April 2018.  Many self employed people also have their accounting year end as 5 April or 31 March to coincide with the tax year. For private limited companies, 31 March is also a common date for the year end. 

Here are some ideas: 

1) Buy business assets and bring forward business expenditure before the year end 

If you are thinking of investing in business assets - new plant & machinery, vehicles, office furniture, computer equipment it is sensible to make your purchase before the end of current financial year, rather than the start of the next one. 

Timing your investment could mean that you can claim your capital allowances sooner, saving on cashflow. Similarly if you are intending to carry out some repairs or maintenance work, doing this before the year end will reduce your next tax bill. 

2) Manage your income

If you are in the fortunate position of being able to manage your income, plan now to optimise your income for tax purposes. For example, as a company director and shareholder, you may be able to reduce salary or dividends to keep your income below the key tax thresholds of £45,000, £100,000 or £150,000. An income level of £50,000 where child benefit is withdrawn from the highest earner in a household is another key threshold to monitor. 

The £100,000 threshold is particularly unattractive from a tax perspective as the personal allowance is gradually withdrawn at a rate of £1 for every £2 of income. This gives an effective rate of tax at a very painful 60% at income levels between £100,000 and £123,000. So best avoided if you don't need the income and can defer this to another year. 

3) Consider the effect of the dividend Tax 

A dividend tax was introduced from 6th April 2016. This affects people who receive a significant amount of dividend income each year – mainly business owners with their own limited companies. 

There is a £5,000 dividend allowance for 2017/18 where dividends are free of tax. The dividend allowance is reduced to only £2,000 per annum from 2018/19 onwards. It makes sense to use this allowance if you have scope to pay a dividend. Above this level new rates of dividend tax apply for varying levels of income. 

The dividend tax has a significant impact on business owners who may be used to drawing a relatively high proportion of their income as dividends. If possible the higher and additional dividend rates of 32.5% and 38.1% respectively are best avoided by capping gross income at the basic rate threshold of £45,000 if this is feasible. Gifting shares to a spouse so that they can utilise the dividend allowance may be appropriate in some cases. 

4) Contribute to a pension 

Pension contributions before the year end are a tax efficient way of saving for the future and reducing your tax bill. This tax savings are particularly attractive for higher and additional rate taxpayers. Advice should be sought from a suitably qualified Independent Financial Advisor to ensure that your particular circumstances are considered. 

5) Use gift aid for donations 

Using gift aid for charitable donations has the effect of raising the basic rate tax band and saving 20% tax for higher rate tax payers. So for every 80 pence you donate, your chosen charity receives £1.00. 

6) Use your tax free savings allowance 

If you are lucky enough to have surplus cash, make sure that you use your annual ISA allowance. Within an ISA, all income and gains are tax free. You can save up to £20,000 for 2017/18. You can choose how you split this between stocks & shares and cash ISAs. There are also new ISAs such as the Lifetime ISA and ͚Help to Buy͛ ISA which are aimed at first time home buyers and offer additional incentives. 

7) Use your annual capital gains exemption 

If you have personal assets (shares, property etc) and are intending to sell them soon,  consider the capital gains tax implications in advance. You may be able to time the sales of shares for example to spread over 2 or more tax years and utilise your £11,300 annual exemption for 2017/18 effectively. 

For married couples and civil partners consideration should be given to each spouse/civil partner using their allowance. 

8) Set money aside for your tax bill 

If you take some of the steps above you should be able to reduce your 2018 tax bill. It is unfortunate that however much we plan, many of us will still be faced with a tax bill for 2017/18, payable in the following January. Setting aside a percentage of your income to cover your tax bill and placing it in a deposit account is a sensible measure and will help avoid any last minute panics trying to find the funds. 

Another tip is to get your tax return completed as soon after the end of the tax year as possible. This gives you an early warning of any additional tax due so that you have sufficient time before the payment deadline in January. 

If you would like Base52’s advice and assistance with any aspect of your tax planning, please contact us.

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