Most of our firms’ clients operate as owner managed limited companies for some very good commercial reasons.
Firstly, limited companies provide the business owner with legal protection from the debts of the company. Therefore, the business owners’ personal assets are safeguarded should their business be unable to pay its own debts.
Secondly, operating as a limited company saves the owner tax. There have been some important changes in the tax rules in recent months. Hopefully, you are already aware of these. However, I am often asked the same question over and again.
Most owners of limited companies draw money from their company that is a mixture of salary (around £8,000 or £10,600) and dividends as the balance. It is the latter that is creating the changes in tax rules.
The new Dividend Tax
There is a new regime for the taxation of dividends in respect of all payments made on or after 6 April 2016. In broad terms, the income tax payable on dividends from that date will be subject to an extra 7.5% tax. Up to 5 April 2006 when a dividend is paid it carries with it a 10% notional tax credit and this tax credit satisfied the tax liability on dividends falling within the basic rate band (of £42,385 of total income). From 6 April 2016 the notional tax credit is to be abolished. The tax credit can never be reclaimed e.g. by low earning non-taxpayers who receive dividend income.
From 6 April 2016, everyone will be entitled to a £5,000 tax free dividend allowance and although this sounds generous the allowance also reduces the basic rate band by £5,000. Any dividends paid above £5,000 will be subject to tax at 7.5% where they fall within the basic rate band. If dividends are paid in excess of the basic rate band, and after deducting the £5,000 allowance, then tax at 32.5% applies for higher rate taxpayers. Dividends are treated as your very top slice of income i.e. after salary, rents and interest have already been taxed and used up any available personal allowance of the tax year.
For the avoidance of doubt, from 6 April 2016, if you are a higher rate taxpayer and have dividend income of no more than £5,000 pa then this will be totally tax free. Before 6 April 2016, you would have had to pay an effective tax rate of 25% on any dividends received.
Every taxpayer has a £5,000 dividend allowance. Therefore, consider using this allowance by paying all adult relations or family members a dividend of £5,000. Children, i.e. those under 18, cannot legally own shares in their own right.
Other consequential changes
The tax advantages of trading as a limited company for most of our clients are still worthwhile, even after the extra 7.5% dividend tax. If you have company profits in excess of £130,000 and draw your profits mainly through dividends then you can be worst off trading as limited company compared to a sole trader or a partnership. However, tax should not be the only factor when considering the method how you trade.
There are a number of alternative methods of profit extraction that will help to reduce the dividend tax. You may consider the following:-
Paying interest from your company to yourself. From 6 April 2016, a new £1,000 personal savings allowance is introduced. This allows you to receive interest of up to £1,000 completely tax free. With extremely low levels of interest being paid by banks then many clients are not using this allowance. If you had £50,000 in a bank paying 2% interest, if you are lucky, then this would generate £1,000 of interest. If you have a large director's current account e.g. built up from undrawn historic profits or you’ve lent your company money then you can exploit this new allowance. Any interest paid must be commercial. What is commercial? The answer is whatever interest rate that any other business would lend to your company at. You may consider an 8% rate. Therefore a £12,500 director's current account balance charged at 8% would result in £1,000 of interest. This will save your company £200 in Corporation Tax. If you and your partner have similar balances then could double the saving. Beware that if you are or become a higher rate tax in the tax year then only £500 of personal savings allowance is available.
As announced last week, the Chancellor has backtracked on his ideas on removing tax relief on pension payments. If you own a limited company and make personal pension contributions then maybe it’s time to stop making them personally. There is no point paying dividend tax to extract profits from your company to then put them into a pension scheme. Instead, avoid the dividend tax of 7.5% or 32.5% by making all future pension contributions directly to the pension company as company paid employer contributions. On a £10,000 pension payment this would save you £750 of dividend tax if you are a basic rate taxpayer or £3,250 if you are a higher rate taxpayer.
Charging for services and equipment provided to your company
Any such charges made to a company, so long as charged at a commercial rate, will save Corporation Tax at 20% on the amount charged. The owner will then be taxable on the income. If the personal allowance, of £11,000 in 2016-17, has not been used then they will be received tax free. Otherwise tax will be payable at 20% (assuming they are a higher rate tax payer) or 40% (if a higher rate taxpayer) on the amount charged. This may be tax neutral for a basic rate taxpayer. However, it does mean that the amount charged has been extracted without paying any dividend tax at 7.5% or 32.5%.
Rent for home
Paying rent from your limited company to yourself. This may use up part of the unused personal allowance, of £11,000 from 6 April 2016, particularly if your only other taxable income is £8,060 pa salary from your limited company. This results in savings Corporation Tax, at 20%, on the rental income and possibly with no personal to pay. At the very least it extracts profits from the limited company, into your hand, with no dividend tax to pay.