Time for a fresh look at tax efficient profit extraction?
For owner managed businesses (OMBs) operating as a limited company, taking dividends has long been a popular method of extracting business profits. On 6 April 2018, the annual tax-free dividend allowance reduced from £5,000 to £2,000. This change could tip the balance on existing profit extraction plans, creating the need for a new strategy.
Dividend taxation changed substantially in 2016 when the 10% dividend tax credit was abolished. This was initially replaced with a £5,000 Dividend Tax Allowance.
In the last tax year shareholders with no other income could make use of the £5,000 allowance, plus the personal allowance of £11,500, to extract up to £16,500 of income from their business without incurring any further personal tax charges. For 2018/19 a reduced dividend rate of £2,000, plus the slightly increased personal allowance of £11,850 provides a total of £13,850 tax free – a £2,650 reduction from the previous year.
With this change in mind, are dividends still the best way to extract business profits?
There are many commercial and practical considerations to take into account when deciding the best method of extracting profits from a company for shareholders. Below are just a few of them.
Dividends vs salary/bonus
Different tax rules apply depending on whether a dividend or a bonus is paid. For an individual, income tax is paid on both bonuses and dividends, but different rates apply to each, current rates can be found in our 2018/19 tax rates and allowance guide.
For the company, payments of salary or bonuses attract company corporation tax relief saving the company 19% on amounts paid. No tax relief is given to the company if dividends are paid. Directors will want to strike a balance between saving tax on their own income and tax on company profits.
Both the company and the individual will pay National Insurance Contributions (NICs) on a bonus or salary worth more than £8,424 a year (at current rates). This is sufficient to count as a qualifying year for State Pension purposes (if above the £6,032 lower earnings limit), so it is usually advisable to take at least this much as salary or bonus. Depending on the circumstances, sometimes National Minimum Wage (NMW) rates and other commercial drivers need to be considered when setting the level of salary for the business owner.
Dividends do not normally attract National Insurance costs for the company or the shareholders.
Marital tax breaks
If both spouses are involved in running the business, this can create the opportunity to utilise two dividend allowances and basic rate bands. It is also possible, in some situations, to enhance company exemptions from Class 1 NICs by utilising the employment allowance. This may be available to pay the first £3,000 of employers’ NICs, but careful consideration of the levels of pay and the exact circumstances are essential to assess if this is in point.
Cash flow implications
It’s important to note that the tax liabilities that arise from dividends and bonuses are paid at different times:
- Income tax and NICs on a bonus are paid over to HMRC on the pay date;
- Income tax on a dividend is payable by 31st January following the end of the tax year (or 50% by 31 January during the tax year and 50% by 31st July after the tax year where payments on account (POAs) apply); and
- Corporation tax is payable nine months and one day after the end of the accounting period for all but the largest companies
As the tax on dividends is payable after the tax on a bonus, the dividend will have a cash flow advantage over the bonus – although this can quickly turn into a cash flow problem if you are not setting aside the tax that will be due as you go along.
Keep in mind
Despite the tax advantages provided by dividends, there are a few factors that you should remember.
The company must have sufficient distributable reserves from which to pay the dividend. If the dividend is unlawful it may be classed as a loan from the company, which could have corporation tax and benefit in kind implications.
All dividends must generally be paid proportionately to shareholders of the business.
It should also be remembered that dividends are not earnings for tax and other purposes. You will need to carefully consider the implications for pension contributions, NMW, state benefit contributions, life assurance policies and corporation tax reliefs, along with many other practical aspects.
Other profit extraction methods
Here we have predominantly focused on dividends vs bonuses and salary, but there are other methods of profit extraction that may be appropriate to your individual situation:
Interest on director loans – pay an individual interest on funds loaned to the company (and remember that the company may need to account for basic rate deduction via the CT61 form).
Rent on assets – paying rent in respect of assets owned by the individual and used by the company can be efficient, but you will need to carefully check the implications on your personal tax position and consider the impact on Capital Gains Tax (CGT) that may arise further down the line when the asset is sold.
Pension contributions – make pension contributions, bearing in mind the current £40,000 annual allowance upper limit.
With such a wide range of options available, that vary heavily dependent on circumstances, it is important to find a profit extraction strategy that best suits you and your business.
For advice on tax efficient profit extraction for your business contact Anne-Maree Dunn.