One of the main attractions of starting your own business is the benefit of dividends. They are payments from company profits which conform to different tax rules that normally apply to income paid in a salary.
The rules for dividends are changing from the 6th of April 2016. The changes mean that a bit more tax will need to be paid than previously, but dividends still represent a good deal for business owners and shareholders.
What are dividends?
A dividend is a payment made to company shareholders from company profits after tax. Imagine that your company has made £100,000.00 pre-tax profit, the chancellor takes £20,000 (20%) in corporation tax leaving you with £80,000 in taxed profit. This £80,000 is where the dividends comes from.
If you are the only shareholder in your company, this dividend payment is made to you. If there are multiple shareholders in your company, the £80k gets divided up amongst them depending on how many shares they have.
What are the advantages of dividends?
Figures used here have been rounded up for simplicity and to illustrate how the system works. You should treat all figures shown as approximations.
You may wonder why, in the above scenario, you wouldn’t just pay yourself more in a salary from the company rather than leaving the money there as profit till the end of the year. The answer is essentially because of the tax bill.
Consider the above scenario where a company has made £100,000 profit. This is profit after paying everything out including wages to staff and your own wages. Typically you would pay yourself approximately £11,000 in wages because paying any more you would start incurring income tax. This is common practice amongst small business owners.
So the Chancellor has taken his cut and you are left with £80,000 for dividends and in this scenario you are the only shareholder.
When it comes to paying out the dividend you get £5,000 tax free allowance, then pay 7.5% tax on the next £26,000 (at which point the dividend pushes your total earnings into the next tax bracket), then 32.5% on the remainder (£49,000 in this example).
So if we take this example we have your earnings as being £11,000 in salary and £80,000 in dividend. You pay no tax on your salary as it is within your personal allowance. The first £5,000 of your dividend is also tax free. The next £26,000 is taxed at 7.5% (= £2,000) and the next £49,000 is taxed at 32.5% (=£16,000). Total tax bill for your earnings = £18,000.
If you were to just pay yourself £91,000 in salary instead of using dividends, your tax bill for your earnings would be nothing on the first £11,000 (personal allowance), 20% on the next £31,000 (=£6,000) and 40% on the remaining £38,000 (=£15,000). Total tax bill on your earnings = £21,000.
So dividends represent a huge saving on tax but that isn’t all. Dividends are not liable for National Insurance payments like salary payments are. So to the salary side of this comparison, you can add 12% contribution to NI up to £42,000 (=£5,000) and 2% on the remaining £38,000 (=£800) total NI contribution £6,000 making the total deductions from your salary = £27,000.
So pay £18,000 in deductions to your earnings with dividends or pay £27,000 in deductions going with the salary route. If that has whet your appetite, wait till you see what else can be done.
So what else can be done with dividends?
Reducing the deduction that you incur on your earnings is just the start. You may consider some further advantages such as paying dividends into a pension fund or ISA. The different tax rules for these ‘vehicles’ mean that at a certain point, when your company is profitable enough, it will make very good financial sense to allocate some shares (and the portion of dividends that go with them) to an ISA or pension fund. The right time to arrange this depends entirely on you and your personal circumstance. You should seek the professional advice of a chartered accountant when considering this option. Another thing you can do is allocate a portion of your company shares to your spouse or other family member. This will mean that they will also benefit from the tax free dividend allowance of £5,000. In the example we have discussed previously, where there is £80,000 of clear profit to be paid in a dividend consider the following option: Give half of the company shares to your spouse meaning that you each receive £40,000 in dividends and both of you get £5,000 of it tax free. The remaining £35,000 is subject to tax. Once again, the figures used here are rounded up or down for simplicity and illustration purposes.
For you, you have your £11,000 salary from the business which is covered by your personal allowance. £26,000 of your dividend is taxed at 7.5% (=£2,000) and the remaining £9,000 is taxed at the higher rate of 32.5% (£3,000). Total you pay is £5,000
For your spouse there would be two options depending on if they take a salary either from your business or from another employment.
Your spouse has no employment. In this case they can use their personal allowance of £11,000 and dividend allowance of £5,000 together. Meaning that they do not pay any tax whatsoever on the first £16,000 of the dividend. They would pay the 7.5% rate on the remaining £24,000 (=£2000).
If your spouse is in employment already, their current tax position would have to be taken into account before you redistribute shares to them as it might actually work out to be inefficient for them to take a dividend beyond the tax free allowance.
So here you can see that in the right circumstances, a hefty potential deduction from your earnings of £27,000 is reduced using dividends to £17,000 and then reduced further in the right circumstances to only £7,000. It can seem very complicated, talking about large sums of money, percentages, earnings, tax brackets and so on. As can be seen from the above example, it is very worth your while to take some time to try and understand dividends as best you can. A good accountant will take the time to help you get your head around your company’s figures and will be on hand to give you advice when you want to explore your options.