Following the taxation of dividends being reformed from 6 April 2016, individuals have been entitled to a dividend allowance. However, this allowance was reduced from £5,000 to £2,000 from 6 April 2018. This reduction will cost all individuals who receive dividends in excess of the allowance an additional £225 per annum in tax. Despite the changes to dividends, they still have role to play in extracting funds from a company in a tax efficient manner.
As long as a company has sufficient retained profits, paying dividends can be a tax-effective method of extracting funds from a company. On the downside, the company can only pay a dividend if it has sufficient retained profits from which to do so, and as they are paid from post-tax profits. Dividends are not deductible in computing profits for corporation tax. However, on the plus side, everyone is entitled to a dividend allowance, the rates of tax on dividends are much lower than on other sources of income and there is no National Insurance to pay.
Typically, a tax efficient profit extraction strategy comprises of a salary and dividend. A salary is paid either to the level of the primary and secondary threshold for National Insurance purposes (set at £8,424 for 2018/19) At this level, the salary has the added benefit of providing a qualifying year for state pension and benefit purposes for no National Insurance outlay. Where the company is entitled to the employment allowance (as will be the case as long as the company is not one with a sole employee who is also a director), as long as the personal allowance has not been utilised elsewhere, the optimum salary level will be equal to the personal allowance (set at £11,850 for 2018/19)
Once a salary at this level has been taken, it is generally more beneficial to extract profits as dividends, retained profits permitting. Each person is entitled to a dividend tax allowance. Whilst the allowance is not as beneficial as previously, it still allows for the possibility of tax-free income in addition to the personal allowance. If the personal allowance is not utilised (as it may be the case if a salary of £8,424 is paid), the balance can be set against dividend income (if the individual has no other sources of income), so that dividends sheltered by the allowance are tax-free.
The dividend allowance is not an allowance as such, it is a zero-rate band. Dividends falling within the allowance still form part of band earnings but are taxed at a zero rate.
The fact that all taxpayers, regardless of their marginal rate of tax, are entitled to a dividend allowance provides tax planning opportunities in a family run company. By making all family members shareholders, it is possible to pay dividends to use up their dividend allowance and get some profits out of the company tax-free. Some care is needed here. Dividends must be paid in proportion to shareholdings but using an alphabet share structure (and having A class shares for one family member, B class shares for another, etc) allows dividends to be tailored to the circumstances of the recipient.
Dividends are taxed as the top slice of income and once the dividend allowance (and any remaining personal allowance) have been used up, any remaining dividends are taxed at the appropriate dividend rate. For 2018/19, dividends are taxed at the dividend ordinary rate of 7.5% to the extent that dividends fall within the basic rate band, at the dividend higher rate of 32.5% to the extent that they fall in the higher rate tax band, and at the dividend additional rate of 38.1%, the extent that they fall in the additional rate band.
Once again, the use of alphabet shares makes it possible to tailor dividend payments to family members to take advantage of the lower dividend tax rates, particularly where the basic rate band has not been fully utilised. By utilising basic rate tax bands as opposed to paying dividends at the higher rate will save family members a maximum of 25% tax on dividend payments.
It is critical for shareholders to understand the impact of dividends when looking to extract profits from a company. It is not something that should be looked at retrospectively and shareholders need to be proactive in their approach to be able to minimise tax liabilities where possible. An understanding of salary and dividend will allow an individual to be able to calculate their personal tax liability before it is due. This will allow an individual to make decisions whether to increase or decrease dividends and to have funds available to pay the liability at the appropriate time.
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