We all love being paid for doing our work whether we are employed or self-employed. However, following changes in the tax on dividends introduced in April 2016, those of you who are your own boss will almost certainly need to reconsider what you should pay yourself as a salary or dividends from your limited company.
In this article, we outline what methods directors of their own company might use, before you discuss what action to take with your accountant.
In 2016, the employment allowance for sole director limited companies was abolished but paying yourself a salary may still have many advantages.
By receiving a salary in excess of £490 per month, you maintain your National Insurance records which gives you access to certain state benefits such as the state pension. Furthermore, the salary is a tax-deductible expense for your company and assuming your company is your main source of income, your monthly salary payment should not be subject to tax or National Insurance (up to a maximum of £680 per month for 2017/18).
If you do opt to pay yourself a salary, your company will need to be registered as an employer and run a payroll which complies with Real-Time Information (RTI) rules.
What is a dividend?
The Board of Directors can decide if dividends should be paid to shareholders and how much. Dividends must be paid out of profits and will be paid to shareholders in accordance with the level of their shareholding. They are not tax-deductible expenses and there must be paperwork to document dividends, such as a Board minute and dividend voucher.
The tax on dividends
Dividends received by basic rate taxpayers used to effectively be tax-free. But in April 2016, the rules changed significantly. Paying yourself a dividend is no longer as cheap as it used to be, but dividends can still be more tax-efficient than other ways the self-employed pay themselves.
The first £5,000 (£2,000 from April 2018) of dividends is covered by the dividend allowance and is tax-free. Dividends more than the dividend allowance are subject to the following rates:
- Basic rate – 7.5%
- Higher rate – 32.5%
- Additional rate – 38.1% (please note that if your income is more than £100,000 your personal allowance starts to get restricted)
For this example, we will assume that you have no other income, because any other source of income (such as rental income, interest etc.) would have an impact on your tax position.
Your annual salary is £8,160, made up of 12 monthly payments of £680. By drawing this from your company, you can then pay £5,000 plus the remainder of your personal allowance as dividends without any tax i.e. £5,000 + (£11,500 personal allowance less the salary of £8,160) = £8,340. This means a total of £16,500 will be tax free (dividend allowance + personal allowance).
Once the above has been taken into consideration and you have claimed your personal and dividend allowances, the next £28,500 (£26,500 in Scotland) of income will be subject to tax at a rate of 7.5%.
If the dividend income exceeds £36,840, it will attract tax at a rate of 32.5%. Should your total income exceed £100,000, you should review the tax allowances and reliefs available to you, otherwise you may start to lose your personal allowance.
Tax variations in Scotland
If you are resident in Scotland and are a higher rate tax payer, you will pay more tax than if you lived in England, Wales or Northern Ireland. That applies even if you earn your income in the rest of the UK or have a company registered in England and Wales or Northern Ireland.
A resident of Scotland will pay £400 more a year if any income subject to the higher rate of tax is received through anything other than dividends (being (£33,500 - £31,500) x 20%).
Additionally, if your income subject to the higher rate of tax comes from dividends the amount of extra income tax due will be £500 a year.
A Sting in the Tail: Payments on Account
A payment on account is an instalment you pay towards the tax due in the following year. You’ll be expected to make a payment on account if your tax bill exceeds £1,000 and if you don’t have a lot of tax deducted at source (i.e. PAYE).
Since the changes to the way dividends are taxed in April 2016, the number of payments on account have risen. Under the old tax regime, basic rate taxpayers were unlikely to pay tax on their dividends so they rarely needed to pay payments on account. However, dividends paid to a basic rate taxpayer now trigger tax at a rate of at least 7.5% so if you receive dividends that exceed any personal allowance or dividend allowance available, you’ll almost certainly have a tax bill to pay.
If your tax bill is more than £1,000, you will have to pay this tax bill and a payment on account- which is half your bill again. This can be a significant and unexpected cost.
We are here to help
If you require further information or think you have been affected by the new dividend tax, contact your local TaxAssist Accountant, on 0131 202 9888 to arrange a free, no obligation meeting to discuss the available options.
By Jo Nockels FCCA
Last updated July 2017