21st July 2016
As a result of changes to the way that dividends are taxed, many limited companies are experiencing a 2016 tax hike.
The changes that are having an impact were introduced in April 2016, removing some of the tax benefits that were previously associated with limited company incorporation.
Limiting tax motivated incorporation
In the past, self-employed people could potentially benefit from incorporating – registering as a limited company – and enjoying the tax cuts that came as a result. This is known as ‘tax motivated incorporation’.
Sole traders could make use of dividends, which were taxed at much lower rates than standard salaries. By taking a small salary and using dividends to top up their income, they could reduce the amount of tax that they paid. For many, this made a lot of sense. In an array of cases, the benefits far outweighed the extra costs and complications of running a limited company.
The Government had an objective to remove some of these tax benefits. That objective is being met by changing the way that dividends are taxed, increasing the amount of dividend tax that most people will pay.
It’s not all bad, however. The new system is easier to understand, involving fewer complicated calculations.
What is the new tax system for dividends?
Introduced in April 2016, the new tax system offers the tax-free Personal Allowance, which every worker receives, and up to £5,000 of dividend income that is also completely tax free.
You could pay yourself £16,000, made up of £5,000 dividend income and £11,000 covered by your Personal Allowance, without paying any tax at all.
As stated on the Government website, you ‘won’t have to pay tax on the first £5,000 of your dividend income, no matter what non-dividend income you have’.
The two allowances – your Dividend Allowance and your Personal Allowance – can both be used together.
Be aware that whilst your Dividend Allowance can’t be used for non-dividend income, your Personal Allowance can absorb some of your income from dividends.
Above the £5,000 Dividend Allowance, there are three rates of tax:
- 5% Basic Rate (up to £32,000 total income)
- 5% Higher Rate (up to £43,000 total income)
- 1% Additional Rate
The £5,000 allowance is not separate from the overall dividend total. If you are paying the higher or additional rate, you will still need to take into account that first £5,000 paid in dividends. This may affect the total amount of tax that you’ll be required to pay.
How do April 2016’s changes compare to the old dividend tax system?
Previously, dividends would be taxed using the following rates:
- 10% Basic Rate
- 5% Higher Rate
- 5% Additional Rate
Under the old system, the basic rate of tax on dividends was higher than it is today. However, Basic Rate taxpayers could benefit from a 10% Dividend Tax Credit which cancelled out this tax. Higher and Additional rate taxpayers could also benefit from the Dividend Tax Credit, even though it didn’t entirely wipe out what they owed.
What differences are there between the old and new systems?
People in the Basic Rate band, who previously would not have had to pay tax on any of their dividend income, will now pay 7.5% if they go above their £5,000 allowance.
The Additional Rate tax has also increased, from 36.5% to 38.1%, affecting the highest earners.
Many people will be paying more tax on their dividends, under the new system.
Is the new system really easier to understand?
Under the new system, there are simple calculations to be made.
If you have any remaining Personal Allowance, your dividends can fall under this. Afterwards, you will benefit from the £5,000 allowance that is specifically set aside for dividends.
You cannot use your Dividend Allowance for other types of income. Therefore, if you earn £20,000 as a salary and the rest of your money in dividends, you can’t use your £5,000 dividend allowance to create a £16,000 Personal Allowance. You can, however, take an £8,000 salary and use your remaining £3.000 of Personal Allowance to cover some of your dividend income.
You will pay tax on any dividends that push you over the £5,000 allowance.
Your total income (salary and dividend income combined) will determine which tax bracket you are in.
If you earn more than £32,000 overall, the first £32,000 will be taxed at the Basic Rate that is relevant for that type of income (either 20% on your salary, or 7.5% on your dividends), whilst anything over this will be taxed at the Higher Rate.
Are dividends still tax efficient?
The Basic tax rate is 20%, the Higher is 40% and the Additional is 45%.
For dividends, these figures are 7.5%, 32.5% and 38.1% respectively.
This means that dividend tax rates are still lower than the alternative.
The tax savings do still exist, but they’re not as significant as they once were. As a result, they might reduce levels of tax motivated incorporation. Registering a limited company may no longer be quite as worthwhile for a sole trader, who might previously have taken a small salary and used dividends to top up their income.
In 2016, it is suggested that the most tax efficient way to take your money within the Basic Rate bracket would be to take a salary of £8,040. This is just below the point at which Class 4 National Insurance contributions come into play. By staying below the £8, 060 limit, you will not have to pay Class 4 NI. £2,960 of dividends can then be included within your Personal Allowance, with an additional £5,000 being covered by your Dividend Allowance, for annual take home pay of £16,000 untaxed. Further dividends will be taxed at 7.5%.
Final things to remember
Your salary can be paid from any money within the company. Dividends can only be paid from profit.
All directors must be paid the same dividend rates. Dividends must also be paid as a one-off sum.
Corporation Tax is due on profits, after salaries have been deducted. Salaries, therefore, reduce Corporation Tax.
It’s important to speak to your accountant, to find the best way to reduce your tax bill.