Tax Motivated Incorporation

There is an inequality in the tax system that affects businesses. The owner of a business operated through a limited company who draws all of his profits in the form of a low salary and dividends will pay less in tax overall than a person operating a similar business as a self employed trader.

The principal reason for this is that in addition to income tax, the self employed trader pays class 4 National Insurance on his profits. The rates applying to profits for the 2015/16 tax year are:
0 – £8060 0%
£8061 – £42385 9%
Above £42385 2%

The owner of a limited company may structure his salary and dividend withdrawals so that he pays the same income tax as his self employed counterpart, but little or no National Insurance.
The inequality itself was created by the government in 1984 and over recent years they have come to realise that many people starting a business or already in business are incorporating for the sole reason that by doing so they pay less tax. The government would like businesses to incorporate:

(a) because of a need for limited liability; or
(b) because they see a need to retain profits to fund growth.

The blunt instrument the government have used to put right this inequality of their own creation is an additional tax on dividends. So from 2016/17 the total tax payable by the two business owners referred to above will be much closer.
In future blogs we will give some worked examples and offer tax planning guidance. But for now we list some FAQ’s about the new dividend tax.

Q1. I have retained profits in my company over the last few years, should I distribute all retained profits this tax year to avoid this new tax?
A. Probably not. If you draw dividends that take you into the higher rate band now you will pay 25% tax on those dividends. If next year your dividends are well within the basic rate band you pay just 7.5%.

Q2. From 6th April 2016 should I simply abandon dividends and draw a salary instead?
A. No, the maximum combined National Insurance rate on salary is 25.8% whereas the additional tax on dividends is 7.5%.

Q3. Does this new tax signal the end of IR35?
A. No, for the same reasons as the answer given above.

Q4. My company is an investment company and owns a number of commercial properties and shares. I draw dividends from this company. If I owned these assets personally I would pay income tax but no National Insurance. Am I exempt from this new tax?
A. Unfortunately not, the dividend tax will apply to all dividends that are not exempt, so this new tax will even apply to dividends paid by listed companies. Dividends paid by Venture Capital Trusts as well as those received within ISA’s and pension schemes will be exempt.

Q5. I have my own company from which I draw a salary of around £10,000 and dividends of around £40,000. I also have a portfolio of listed company shares from which I generate about £4000 per annum in dividends. My wife is employed and receives a salary of £50,000 per annum. Is there some simple tax planning we can do as a family?
A. Yes, if you gift your listed share portfolio to your wife she will receive the dividends generated, and instead of you paying 32.5% she will pay no dividend tax because she has a £5000 allowance.

Q6. I am an IT Contractor and my wife and I each require about £10,000 in salary and £25000 in dividends. I complete a self assessment tax return each year but my wife does not because she is not a director. Will this change?
A. Your wife will need to notify HMRC that she expects to have a tax liability each year from 2016/17. HMRC will almost certainly require her to complete a tax return.

Q7. Is it quite simply the case that everyone in receipt of dividends will see their tax liabilities increase by 7.5% of dividends received?
A. No, the additional tax charge will always be less than 7.5% of dividends received. In some extreme cases individuals will pay less tax than under the present system.

Q8. What general tax planning advice can you offer in respect of this new tax?
A. None, there is no “one size fits all” solution. The need for tailored advice in this area is substantial.