Have the new rules on dividends changed the way paying salaries and dividends should be approached? Here we look at the numbers involved.
Income tax dividends underwent major changes as of April 2016 and as a result they became considerably less efficient for tax purposes. Regardless of the fact that the first £5000 of dividend income is tax-free, everything above that is now a great deal more expensive when it comes to tax.
New v Old Rules
As the table above makes clear, the newer rules are a lot easier to understand – gone are the days of ‘grossing up’ or notional tax credits. As the tax rates show, dividends are viewed as the highest cut of a person’s taxable income. However, they are not seen as a permitted expense from the company accounts. Thus if a company profits by £10,000 it will be required to pay corporation tax at 20%, which amounts to £2000. This will then leave £8000 for dividend income for shareholders. In turn, the individual shareholder will calculate their dividend as 80% (100%-20%) of the total company sum and pay their income tax on that amount.
The Old Tax Rationale
The essential point of tax planning has always been to minimise tax loss of any kind. Previously dividends had been far superior to salary when it came to tax efficiency at all income levels. However, exceptions applied:
- Salary would be tax deductible through the company accounts so the company will pay less tax on bonuses or salaries and more on the profits they pay out.
- Salary wont invoke income tax when it is set against a (tax-free) personal allowance.
- However, it will then invoke NIC’s (National Insurance Contributions) on employees NIC’s at 12% of anything from £8,060 to £43,000 when it would then drop 2%. Similarly at 13.8% over the secondary earnings level of £8,112 (and no upper threshold.)
- Because of the employer’s NIC charge, if a person’s salary tips over the threshold, suppose the company has, say, £10,000 bonus to pay, then the amount of salary (gross) that the employee will receive and against which they can calculate their NIC’s and income tax is worked out as: money available x 100 / (100% + 13.8%). The director would then have to pay the income tax on the lesser amount.
In summary, when someone has no alternative or secondary income source which would affect their permitted allowances, the greater their percentage efficiency the better and the greater the amount that the shareholder / director will have in their hands in the end. The table below details the better options in bold:
It is important to note that the new dividend allowance is not an actual ‘allowance’, rather it is a special 0% band that is applied to the first £5000 of dividend income, if there is any, above the allowed personal allowance. It is therefore able to sit in either the basic rate band, or in the higher rate band or in the additional rate. This will be dependent on how much additional income the taxpayer has before dividends are counted.
Employees national insurance contributions rates do not follow the income tax bands. They have deliberately set the upper limit where employee contributions fall from 12 to 2% at the same as the higher rate threshold.
Standard tax bands are able to be increased by making gift aid donations or personal pensions contributions – the National Insurance upper limit for employees will rest at £43,000.
Personal allowances will be tapered once the income goes over £100,000 which can then ruin the comparison of tax bands.
Employment allowance offers a credit of up to £3000 to set against an employer’s National Insurance Contributions, although it is obviously not really open to ‘one-man’ companies. However, where it is an option and the director is able to benefit, it will have the effect of helping to nullify exposure to the employer’s National Insurance contributions far above the secondary threshold at £8,112.
What that means is that the salary route would retain the 88% efficiency and would indeed be superior to the dividend route. However, once an employee’s income reaches the personal allowance level, they then get the 20% income tax on salaries, reducing the net efficiency from 88 to 68% (100-12-20%.) This is of course inferior to the 74% that is applicable to dividends within the basic rate band (or even 80% if they are within the new dividend allowance.)
The good news is that the traditional salary / dividend balance remains largely the same. Not many one-man companies will have an incentive to increase their salaries up from £8,060 to £8,112 so that they can make a negligible saving, particularly when it would be more than covered by the extra cost of paying National Insurance Contributions to HMRC.
If it is available however, the employment allowance can be genuinely useful and may well be worth it for a company owner to increase their salary to £11,000, although not necessarily in cases where the employment allowance might be used to offset a non-director salary. However, the bad news is that because of the new dividend regime, anyone earning in excess of £150,000 will nowadays be facing a loss of more than 50% of the top cut of their remuneration to a mixture of National Insurance, income tax and corporations tax, regardless of whether they opt for dividends or salary.