Dividends are surplus funds that limited companies pay out to their shareholders. However, this sum mustn’t exceed the company’s distributable profit. It must retain sufficient reserves to be able to pay other liabilities as they arise; for example, corporation tax and payments to suppliers. If a company attempts to pay dividends outside the distributable reserves, even if the cash is available at the time, then they will be deemed to be operating illegally. Companies can choose to corral their profit over several business years before distributing it as dividends or pay as frequently as several times each year.
Over the last few years, dividends have been effectively tax-free for base rate taxpayers. This is unlike salaries which are subjected to income tax and national insurance contributions. For this reason, many small businesses have decided to pay their shareholders (including themselves) through this method. However, on April 2016 new tax, proposed in the recent budget adjustments, will come into effect on all dividends.
For many businesses, this will come as a nasty shock. But the news isn’t all doom and gloom. For starters, the dividends tax won’t come into play until a £5,000 threshold has been reached and after that basic rate taxpayers will only have to contribute 7.5% of their earnings. Although this is a significant rise from paying nothing at all, it is still less than paying income tax and national insurance.
There’s also personal tax allowance to take into consideration. Dividends are still eligible for this, so you won’t pay anything until the both the £11,000 personal allowance (for tax year 2016/17) and the £5,000 dividend allowance has been reached. So, for a single shareholder company with post-tax profits of less than £16,000 a year, the dividend tax never becomes an issue.
The effect of the new dividend tax cannot be fully avoided but a bit of tax management can help. Many owner directors chose to distribute the profits using a combination of salary and dividends. Each director can draw a salary of up to £11,000 with no personal tax liability and minimal national insurance. Unlike dividends, the salary is an allowable cost for the company so its taxable profit is reduced. This saves around £2,200 in corporation tax compared with paying the same amount as a dividend. Although this approach is simple in principle, the details do vary with personal circumstances. Some professional guidance will maximise the benefits whilst staying on the right side of the taxman.