Decision time – dividends or bonuses under the new regime?

By Clare Munro, Tax Partner

As we head into the final couple of months of the tax year there's still time to fine tune your remuneration structure for the best possible tax result. 

The changes to the taxation of dividends which took effect in April 2016 have left many small company shareholders significantly worse off. Many smaller company proprietors arranged their affairs in the past so that their salary used up most of the personal allowance and the dividend up to the higher tax rate threshold was covered by the tax credit which came with the dividend. The result was over £40k without income tax or national insurance costs.

So what to do, now that dividend is received gross and even basic rate taxpayers will pay tax at 7.5% on dividends over the tax free dividend allowance of £5,000? If you’re thinking of taking a dividend before the end of the tax year should you take a bonus instead?

There is no hard and fast rule but in general:

  • The first thing is to maximise use of the £5,000 allowance wherever possible. All taxpayers are eligible for it, whatever their income position, so, unless owners have dividend income from elsewhere or the company has insufficient reserves to pay, owner managers should ensure that the company declares dividends to at least this level.
  • The allowance is more valuable the higher your marginal tax rate, so those paying 45% income tax should definitely aim to take £5,000 in dividends. 
  • For a company whose shares are owned between a married or civil partner couple, two dividend allowances are available and, for those able to split company ownership between the wider family, perhaps taking in the next generation, multiple allowances may be available.
  • It could be worth creating another class of shares for family shareholders to spread the dividend income but it needs some careful thought and planning.
  • Once the dividend allowance has been used up, basic rate taxpayers will generally be better off overall by taking a dividend rather than salaries or bonuses. However the gap narrows for higher earners so that there is now little to choose between dividends and salaries

Overall, small company owners will have to balance dividends vs bonuses and do their sums. In favour of dividends, there is no National Insurance Contribution to pay, either by the employee or employer; the tax free dividend allowance will bring down the effective rate and the 7.5% tax rate beats even the basic income tax rate. On the other hand dividends are paid out of the company’s post tax income, whereas the company gets a tax deduction for salaries.

Much will depend on the income profile of each individual and so there’s no substitute for running the numbers. If you could use a bit of help with your profit extraction strategy in the run up to the tax year end please contact....

If you would like to discuss any of the points raised above please contact our tax partner, Clare Munro

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