Paying a dividend has always been one of the most tax efficient ways of taking money out of a limited company, but new dividend tax changes introduced in the summer Budget will result in higher taxes for limited company shareholders and one-person limited companies.
Despite being presented as a tax cut, the dividend overhaul is actually going to be one of the biggest revenue raisers for the Conservative government, bringing in an estimated £6.8billion over the next five years. This additional revenue will be raised by replacing the existing dividend tax credit with a tax-free dividend allowance of £5,000, with higher taxes on income above that.
The new rules, which come into existence from April 2016, aim to counteract the ‘tax planning’ opportunities available to owners of limited companies. Currently, company owners tend to pay themselves small salaries and take the rest of their income in the form of dividends, ensuring lower tax and no National Insurance liabilities.
How will the new dividend tax rules work?
From April 2016, the first £5,000 of dividend income for each tax year will be tax-free. This is in addition to the £11,000 personal allowance for 2016/17. After that point, any additional sums will be taxed at:
• 7.5 percent for basic rate tax payers
• 32.5 percent for higher rate tax payers
• 38.1 percent for additional rate tax payers
No tax will be deducted at source, so taxpayers will have to use the self-assessment tax system to pay any tax due.
How does this differ from the current system?
Under the current system, as company profits have already been subject to corporation tax, taxpayers in every band pay less than they would on earned income. The following rules apply:
• No tax for basic rate taxpayers
• 25 percent for higher rate taxpayers
• 30.56 percent for additional rate payers
Instead of receiving a £5,000 tax-free allowance, those receiving dividends benefit from a 10 percent tax break. So, for basic rate taxpayers, the 10 percent tax credit means the 10 percent tax levied on dividend payments is reduced to zero.
What is the effect of the changes in practice?
In real terms, what difference will the new dividend tax rules make to the take home incomes of limited companies and consultants?
Let’s take a look at the following example of a one-person limited company who pays him or herself an £8,000 salary and takes £50,000 in dividends:
– The £8,000 salary is tax-free as a part of the £11,000 personal allowance in 2016/17;
– The first £3,000 of dividends is also tax-free thanks to what’s left of the £11,000 allowance;
– The next £5,000 of dividends is tax-free as part of the new dividend allowance;
– That leaves £42,000 of dividends, of which £27,000 is taxed at the basic rate of 7.5 percent (£2,025);
– The remaining £15,000 of dividends is then subject to the 32.5 percent higher rate (£4,875);
– The total dividend tax is £6,900, which is £2,136 more than the dividend tax liability would be under the current rules.
What is the potential impact on company directors?
Although it’s not the case that every company will lose out, the vast majority will. There are a small proportion of company directors who will actually pay less tax as a result of the changes, but only those who are higher rate taxpayers who take less than £5,000 in dividend income.
Should the company find it difficulty in paying HMRC or other creditors the company may well be insolvent. An insolvent consultancy can have a disastrous impact on the director consultant personally. In all likelihood the dividends taken from the company may well be ultra-virus (taken wrongly or directors acting beyond their powers) and need to be repaid if the company is closed via an insolvent liquidation such as a creditor voluntary liquidation or compulsory liquidation. Even were a company rescue package is pulled together creditors and certainly HMRC will insist on the money taken being repaid before a deal is struck. The result from the new rules could be an increase in the number of overdrawn directors’ loan accounts, as directors seek to make up for this shortfall by taking money out of their companies in other ways. If overdrawn directors’ loan accounts are not dealt with properly and repaid in full, they can cause serious problems even causing bankruptcy in insolvent situations, and this is something company directors must be made aware of.
I would urge accountants to be more proactive when it comes to advising one man limited companies even if this means charging more.
How can we help?
The new dividend tax rules are undoubtedly bad news for consultants operating through limited companies who take the majority of their income in dividends. However, it is important directors resist the temptation to simply make up the shortfall by taking money out of the company in the form of a director’s loan, unless they can afford to pay it back. It’s also well worth noting that you should not be taking dividends if your company is not making a profit, as this will add to any existing overdrawn director’s loan. Tax efficiency is one thing but simply taking company funds as your own is not a good idea and never has been.
If your company is insolvent or you are worried about paying a large tax bill and you have an overdrawn directors’ loan, please speak to our team immediately for help negotiating a mutually acceptable settlement. Excluding company voluntary arrangements we agreed over £1.4m in HMRC tax negotiations in the last 3 months alone to 9/12/15. Remember we protect directors. Call 08000 746 757, email: firstname.lastname@example.org, or use the live support feature on our website.
Written by: Mike Smith