The basics – so what's new with dividend tax?

Claire Turner of TLC Accountants helps small businesses get to grips with Dividend Tax changes announced by the Chancellor this week.

Claire Turner

Claire Turner

It was heralded by the Chancellor as something which would impact very few people, but the UK's small business owners will probably disagree when they get to grips with the changes in the way dividends are taxed from this next tax year.

There will be a new tax-free dividend allowance of £5,000 which replaces the current 10% tax credit on dividends. After that, all dividend income will be taxed. That's different to the system now which effectively considers that a limited company has already paid the tax on the income, so as you know at present no personal tax is payable if you are a basic rate payer (it's taxed at 25% of the net dividend if you're a higher rate payer).

The headlines are:

Tax will now be payable on dividends over £5,000 in any one tax year at:

• 7.5% if you pay basic rate tax
• 32.5% if you pay higher rate tax
• 38% if you pay additional rate tax

When will the changes take effect?

The changes come into effect from the new tax year, which starts on 6 April 2016.

How this affects you

So how will these changes actually affect you (and your pocket)? Assuming you only receive income from your business (no pensions, rental income etc.), then from 6th April 2016, for most of you we would recommend as a starting point to take an annual salary of £8,060 (£671.67 a month).  This a reduction from where we are now. This is also because the small employers national insurance allowance of £2,000 has also been withdrawn when a company only has one employee and if you use the allowance already then you only need to be on £8,060.

Let's look at a few different scenarios regarding the dividends you could take moving forward. A lot depends on your attitude to paying tax generally and of course your income requirement:

1. You don't want to pay any tax at all

The maximum dividend you can take is £7,940 (£5,000 allowance plus the remainder of your personal allowance over £8,060). This will give you total earnings of £16,000. This option can be attractive to you if you would like to retain profits in your company and you don't want to pay tax, (nor need the income).

2. Pay some tax, but minimise your tax liability by paying tax once a year only in January (and at the same time avoid making any payments on account for the following year)

The Maximum dividend you can would then take is £21,000. This keeps you tax bill below the magic number of £1,000 – in fact you would owe HMRC £999.98 payable 31st January 2018.  This will give you total earnings of £29,333, including your salary.

3. The general consensus - making the most of the 7.5% band

If you are looking to take the maximum from your company at the 7.5% tax band, then you could withdraw £34,940 in dividends.  This uses your basic rate tax band, resulting in a tax bill of £2,025 payable 31st  January 2018.  Plus a payment on account of £1,012.50 for the following year, meaning the total payment due 31 January 2018 will be a staggering £3,037.50. You will then need to make a further payment on account of £1,012.50 on 31st July 2018.  

Assuming that there are no other major changes to circumstances or tax legislation, you'll then pay around £1,000 every six months. This will give you total earnings of £43,000 (avoiding higher rates of tax).

4. £43,000 and beyond - keeping your child benefit (if relevant) – so keeping below the important 50k limit

If you earn more than £50,000 a year, you will lose some or all of your child benefit. To keep your child benefit intact, you can earn £41,940 in dividends. In doing so, you'll pay a tax bill of £4,300, plus a payment on account of £2,150 on 31st January 2018 (total £6,450).  You'll then pay a further payment on account of £2,150 on 31st July 2018.

5. Taking income up to 100k  - keeping your personal allowance (staying out of the 63% tax bracket)

If you earn more than £100,000, you will start to lose your personal allowance.  You can take up to £91,940 in dividends and retain your full personal allowance. If you do, your tax bill will be £20,550, plus a payment on account of £10,275 (total £30,825) due 31st January 2018. You'll then need to make a further payment on account of £10,275 on 31st July 2018.

Other considerations

The main burning question we are facing is ‘Should you now be bringing your dividends forward to this current tax year to avoid the extra dividend tax after 6th April 2016?' The answer is YES - if you haven't used up all your basic rate allowance, then it would be wise to declare dividends early. This will save you a straight 7.5%.

But please note accelerating a dividend that takes you into the next tax bracket is a bad idea (unless you will be in the higher tax bracket next year). Whatever action you choose to take you should remember that dividends are a distribution of profit after tax – so you need to have made enough profit to cover any dividend you declare.

Having other sources of income (such as property income or pension income) will also affect your tax bill and adjustments will need to be made to these figures.  It is also worth considering the use of spouses and possibly other family members 5k dividend allowance and lower rate tax bands. This only works if they have £5,000 of their basic rate band remaining and stay within the basic rate - please take professional advice. This tends to work well for one-man band companies that don't have complications of shareholders agreements etc. The savings of doing this are a minimum of £375 per annum but potentially a lot more - £1,250 per annum if you are able to save higher rate tax – something to consider.

The Future?

We are now seeing a lot more businesses opting for limited companies for non-tax reasons (mainly the limited liability protection) rather than tax lead incorporations, as we have in the past. The tax gap between being limited and a sole trader has now substantially reduced.

There are certain levels of income where the changes in tax make quite a big difference. For example, if you have profits of £30,000 you will currently save £1,612 by operating through a limited company rather than being a sole trader. That saving reduces to £861 under the new proposals. So it's not going to be as attractive for some to incorporate at present.

Claire Turner is a Director at TLC Accountants