Owner/managed companies hit for six

The new basis of taxing dividends, which will come in from 6 April 2016, is particularly targeted at company owner/managers who draw profits as dividends rather than as salary in order to avoid paying NICs.

The existing 10% tax credit is to be replaced by a tax-free dividend allowance of £5,000 for basic, higher and additional rate taxpayers. Once the allowance is exceeded, dividends will be taxed at:

  • 7.5% within the basic rate band.
  • 32.5% within the higher rate band.
  • 38.1% within the additional rate band.

The overall effect of these changes will be to increase the rate of tax on dividends above the tax-free allowance by 7.5% compared with current rates.

The allowance is not quite as generous as it could be, because it counts towards the basic and higher rate bands, effectively acting as a nil-rate band. So it’s not really a tax allowance in the usual meaning of the phrase. Owner/managers typically draw a small amount of director’s remuneration to preserve their entitlement to the state pension and take the remainder of their drawings as dividends.

 Most will see a substantial increase to their tax bills from 2016/17 onwards compared with this year. For example, take a company with profits of £50,000 of which the owner/manager draws £8,000 as remuneration and a further £33,500 as dividends. Using estimated 2016/17 rates, the overall tax and NICs will go up from £8,900 in the current year to £10,312, an increase of £1,412.

The extra tax cost gets even worse as the level of dividends increases. So with profits at £100,000, salary of £8,000 and dividends of £73,500, the tax will go up from £28,900 to £32,937 – an increase of £4,037 for 2016/17 compared to 2015/16. The problem is doubled where spouses or civil partners run a company together.

Despite the changes, the dividend route will continue to be far more tax efficient than taking director’s remuneration.

Time to incorporate?
The big question is, however, whether incorporation will still be worthwhile. Using estimated 2016/17 NIC rates, the total tax and NICs will be £12,632 for a self-employed person with profits of £50,000. The total will be £33,632 where profits are £100,000. The incorporated figures look slightly better because a small amount of profit is retained in the company. So incorporation can still have a tax advantage, and the saving would be greater if some profits were retained. Another benefit of incorporation is that even if profits fluctuate, the level of drawings can be kept constant – maybe within the basic rate band.

Mitigating the impact
Apart from retaining profits, there is no easy way of avoiding the new tax rates. However, it might be possible to mitigate their impact:

  • An owner/manager could charge a commercial rent for company use of an office space in their home – rent is not subject to NICs.
  • Interest could be charged on a director’s loan account with the company, especially if the owner/manager can make use of the £1,000 tax-free savings allowance.
  • It might be possible to run a small section of a business on a self-employed basis alongside a company. Class 4 NICs are avoided if profits are kept below the lower limit, and although class 2 NICs will probably be payable, these may be abolished.
  • Another possibility could be using the dividend allowance of a partner or adult children by bringing them in as shareholders.

So incorporated businesses should probably remain as they are, at least for now, but the decision is no longer so clear cut for unincorporated businesses that might be thinking of incorporating – especially when the simplicity and cost savings of being unincorporated are taken into account. And of course the dividend tax rates could be increased in the future.

You might want to think about taking dividends before 6 April 2016. Apart from pre-empting the tax increase, doing this may increase your loan account with the company so that it can pay you more interest in the future.

This is a new and complex area, so if you need any advice then please get in touch. We are here to help.