The main options are:
What is better, pay or dividends?
Dividends are often combined with a salary to get the most tax effective extraction of profits when a business is carried on through a company. For many years it has been attractive to pay a small salary to allow the tax efficient use of the personal allowance, to provide a corporation tax deduction for the company but not to pay National Insurance contributions (NICs). This means a salary of £680 a month in 2017/18. This also results in a qualifying year for the state pension.
A new tax regime for dividends was introduced in April 2016 which resulted in many director-shareholders paying more tax on dividends. Does this change the mix of low salary and the remainder as dividends?
The Dividend Allowance of £5,000 does not change the amount of income that is brought into the income tax computation. Instead, it charges the first £5,000 of dividend income at 0% tax. This means that:
The result is that a low salary and the balance of income taken as dividends will still be tax efficient for many director-shareholders. This is likely to be the case even when the Allowance reduces to £2,000 in April 2018.
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For a higher rate taxpayer who just pays 2 per cent employee NICs, it would cost the company a gross £1,962 in salary or bonus to pay such an employee £1,000 net. The company should then qualify for 20 per cent corporation tax relief on this amount, bringing the net cost down to £1,570.
In contrast, if the company paid the individual a dividend, the higher rate taxpayer would have to pay 32.5 per cent tax on the dividend, and the company would therefore have to pay a dividend of £1,481.48 for the shareholder director to have an after-tax income of £1,000. That is just 5.6 per cent less than the bonus, so it is still worthwhile. The NIC saving outweighs the extra dividend tax.
Paying interest to the director-shareholder
Interest receipts are the main category of savings income. There are two tax breaks which can apply to savings income. One is the Savings Allowance which was introduced from April 2016. The Savings Allowance, which is £1,000 for basic rate taxpayers and £500 for higher rate taxpayers, charges interest up to these amounts at 0%.
The other tax break on savings income, the 0% starting rate of tax on savings income, has been around for many years but until recently it did not provide significant tax savings. The 0% starting band now potentially applies to £5,000 of savings income. This rate is not available if ‘taxable non-savings income’ (broadly earnings, pensions, trading profits and property income) exceeds the starting rate limit. However, dividends are taxed after savings income and thus are not included in the individual’s ‘taxable non-savings income’.
It is quite reasonable for the company to pay interest to its director on any credit balance in the director’s account, or on funds the director has provided to his company. However, the interest should be calculated at a commercial market rate, not at loan-shark rate.
Jane is a director-shareholder and has made loans to her company. She may be able to charge £5,000 a year based on the amount she has lent and a market rate of interest. She takes a small salary (approximately £8,000) and the balance as dividends (typically about £50,000). The salary would be covered by the personal allowance (which is £11,500 for 2017/18), with the dividend receiving the benefit of the remainder of the personal allowance – so £3,500. The rest of the dividend would be taxed at Dividend Allowance rate (0%), basic rate (7.5%) and higher rate (32.5%).
If £5,000 of interest was received there is an opportunity to benefit from the 0% starting rate on £5,000 of the interest. Personal allowances can be allocated in the way which will result in the greatest reduction in the taxpayer’s liability to income tax and so, in this example, £3,500 would still be allocated to dividends as in the previous paragraph. Jane would have the benefit of the £5,000 interest being tax free rather than £5,000 dividends taxed at 7.5% (a saving of £375). There would also be a saving to the company as the interest paid is generally deductible from taxable profits which gives a saving of £5,000 at 19% (£950).
To formalise the payment of interest on a director’s loan account an agreement should be drawn up between the company and individual setting the interest rate (or range of rates) and repayment terms.
Paying family members
Companies often seek to minimise the tax position of director-shareholders by involving members of the same family and using personal reliefs and lower rate tax bands of each person. Income is therefore diverted from the higher rate taxpayer. However, anti-avoidance rules need to be considered as to whether a diversion is effective. This is particularly relevant for married couples.
Where it is considered that arrangements have been made by one spouse which contain a gift element, then the ‘settlements’ rules may apply and the person who made the gift, rather than the recipient of the income, will be taxable on that income. A key purpose of these rules is to ensure that income alone or a right to income is not diverted from one spouse to the other. Genuine outright gifts of ‘normal’ share capital from which income then wholly belongs to the other spouse are not caught by the rules because of a specific exemption from the settlement rules.
Family company shares and the dividend income derived therefrom can be challenged by HMRC in some cases. An example of a structure which may be challenged is the issue of a separate class of shares with very restricted rights to a spouse, with the other spouse owning the voting ordinary shares. Another area of potential risk is the recurrent use of dividend waivers particularly where the level of profits is insufficient to pay a dividend to one spouse without the other waiving dividends.
Relief for individuals’ contributions - An individual is entitled to make contributions and receive tax relief on the higher of £3,600 or 100% of earnings per tax year.
A company will normally obtain a tax deduction against its profits for pension contributions. The contributions must be paid before the end of the accounting period in order to obtain a tax deduction in that period. Employer pension contributions are tax and NIC free to the director-shareholder as long as the ‘Annual Allowance’ of the director-shareholder is not exceeded.
Broadly, the Annual Allowance is £40,000 per tax year but unused amounts of £40,000 from three previous years may be able to be brought forward. However, there are complex rules which apply to those with ‘adjusted income’ over £150,000, which can reduce the Annual Allowance to as little as £10,000, so detailed advice should be taken before any pension planning is undertaken. The following example helps explain the potential benefits.
Conclusion - the tax system allows savings but planning is required.