A lot has been said about the impact this year’s dividend tax changes will have on investment decision-making. Not so much has been said, however, about how those changes will affect the decisions around how to most tax-efficiently extract funds from a company for owner/managers.
Giving informed guidance on this most important question should be within the core competence of an adviser to businesses. There are a number of factors to take into consideration, including:
- The corporation tax rate
- The income tax rate of the receiving party
- National Insurance
- The potential to “channel” funds through a working or shareholding spouse of an owner/manager (shareholding director)
- The potential and attraction to the owner/manager of pension contributions in relation to funds not needed for current expenditure
- The potential impact on entrepreneurs’ relief (10 per cent CGT on cumulative lifetime gains of up to £10m) of building up funds in the company for “extraction” later through business sale or liquidation.
All these factors (and more) mean the choices available to owner/managers are extensive and far from easy. Informed advice is essential.
Once it has been decided the funds are not to be left in the company (and it should be borne in mind there is consultation on action to prevent so-called “money-boxing” – namely the build up of cash from profits followed by its extraction through liquidation at a 10 per cent entrepreneurs’ relief rate, followed by the setting up of another company following the same strategy), then the most obvious choices for extraction for owner/managers’ current use are dividend or salary.
Of course, as noted above, corporate and personal tax rates can have a big influence on the extraction choices. The arrival of 2016/17 marked the start of the new dividend tax regime, specifically targeting shareholder directors who used high dividends in place of salary/bonus payments, as well as a cut in the standard lifetime allowance and the introduction of annual allowance tapering for high earners.
Both these changes have an impact on the salary versus dividend decision. Some of the basic considerations in making the selection should include:
- Generally, a salary of £8,060 will make sense before any other payment is considered. The figure is chosen to match the primary earnings threshold and means there is no employee or employer NIC involved, but the employee gains an NIC contribution record.
At this level, the salary will also fall fully within the individual’s personal income tax allowance, assuming there is not more than £2,940 of other earned/pension income and that the personal allowance is not subject to £100,000+ tapering. Salary is an allowable expense, so provides a corporation tax saving.
- A further consideration is the employment allowance, which effectively negates the first £3,000 of employer’s NIC but not (for 2016/17 onwards) for companies where the director is the sole employee. This is an obvious incentive for a director of a one-person company to employ their spouse/civil partner, typically paying up to their available personal allowance. If the spouse/civil partner is already a taxpayer (through investment income and/or pension income), then it will usually not be worth paying them beyond £8,060, as otherwise costs would be incurred. There will be tax on these earnings but at the margin this will generally be less than the alternative of a dividend payment to the director.
If there is any unused employment allowance after covering employer’s NIC payments for other employees, then on an increase in the director’s salary NIC could be saved. The saving would be made on earned income in excess of £8,112. However, the net benefit beyond £8,060 is reduced because 12 per cent employee NICs will bite.
Once both employer and employee NICs bite, dividends become a more attractive option, where payment is possible. The table above looks at the marginal situation above the (employer’s) secondary threshold of £8,112. As the rate of tax on earnings in this band will never be less than that on dividends, the dividend wins.
I will continue this analysis next week.
Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn