In light of recent proposed changes to dividend taxation it is not surprising to find that many business owners have approached us to reconsider how they can extract income from their companies.
Having introduced a new tax free allowance on dividend payments of up to £5,000 in April 2016, the government announced an intention to reduce this in the 2017 Budget, when it was proposed that the allowance will fall to just £2,000 from April 2018. Prior to the £5,000 tax free limit, business owners had benefited from a regime in which basic-rate taxpayers paid no further tax on their dividend income. Higher-rate taxpayers incurred an effective rate of 22.5%, whilst additional-rate taxpayers paid 27.50%. With Parliament disbanded before legislation could be approved to bring these changes into force from April 2018, the proposals remain and will be revisited the other side of the forthcoming General Election.
With the current uncertainty associated to dividend taxation, it is natural to revisit whether you are paying yourself in the most tax-effective manner. The answer to that question will very much depend upon your personal circumstances and that of your business, and we would always advise you to seek professional advice.
For example, though the new dividend taxation structure may be a bitter blow to many business owners, this may not necessarily mean that you should move away from dividends as a way to draw an income from your business. Alternatively now may be a time to consider alternative profit extraction structures such as a company pension contribution.
Dividends received in excess of the tax free allowance are taxed at set rates of 7.5% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers. This compares with income tax rates of 20% for basic rate, 40% for higher-rate and 45% for additional rate taxpayers. On the face of it therefore income taken as a dividend is preferable to income taken as a salary.
Corporation tax should also factor into your decision making. While salary and pensions are paid before corporation tax is calculated, dividends are paid out after. This should be taken into account when the overall tax effectiveness of dividends is considered. The good news on that front is that corporation tax fell in April 2017 to 19% and will fall further in 2020 to 18%.
It is also worth bearing in mind pension contributions when planning in this manner. Just like salary, pension contributions made by the business are paid out before corporation tax is calculated therefore reducing the corporation tax bill. Once funds are within a pension, they are outside of your estate for inheritance tax, grow free of any income or capital gains tax and when drawing the benefits from your pension, the first 25% is tax free and tax only applies on the remaining 75%. More often than not therefore, making a pension contribution is a more tax efficient way of withdrawing funds from your business than salary or even dividends.
As you can see from the above, there are many factors to consider when addressing the income you take from your business – including many not listed here. If you would like to discuss your individual circumstances with us then please contact your Creative consultant, or email us at email@example.com, and we’ll be happy to discuss the options when it comes to your future plans.