How dividend tax rise hits small business owners
The government’s recent announcement that it would increase both the dividend tax and National Insurance by 1.25% has been described as another blow to business owners, particularly those that are already struggling as a result of supply chain disruption, labour shortages and the ongoing impact of the pandemic.
What are dividends?
A dividend is a payment of profits (after corporation tax) to shareholders of a company. Business owners can pay themselves through a salary or dividend, or a combination of the two. Profits extracted from the company can be spent freely, whereas funds reinvested must be applied wholly and exclusively for the benefit of the company.
What are the benefits of paying yourself dividends from your company?
From a tax perspective, it has historically been beneficial to extract income in the form of dividends, as dividends have attracted lower rates of income tax than being paid a salary. Additionally, each person has a tax-free dividend allowance (currently £2,000) which means that tax is only payable on dividends above this rate. This allowance is on top of the income tax personal allowance, so it can be advantageous to utilise these allowances by taking income as a combination of both salary and dividends.
Investors should check their other investments where dividends are received, as these may mean that part or all of the tax-free dividend allowance for the given period has been used. It is sometimes possible to pay dividends to your spouse to access their tax allowances, if they are a full shareholder in their own right.
Paying yourself a dividend (as opposed to a salary), will be exempt from National Insurance contributions for both you and the company/employer. However, a dividend is paid out of profits after corporation tax, and so business owners should take advice to ensure their position is optimised. With tax rates going up it is sensible to consider taking dividends in the current tax year, before the tax rises take effect.
Who benefits from dividend payments?
Dividends are currently taxed at lower rates than a salary, with a top dividend rate of 38.1% (rising to 39.35% from 1 April 2022), compared with a top salary tax rate of 45%. But dividends are paid after corporation tax, which of course is also increasing to a 25% headline rate in 2023 (but with marginal relief between £50,000 and £250,000 of company profits).
Business must be making a profit (after tax) to make dividend payments. Provided this is the case, one way in which companies can benefit from paying dividends is through shareholder loyalty and retention of investors.
From the viewpoint of an external investor, a big advantage of receiving a dividend is that it is money ‘in the bank’ and represents a return on investment. In times where stock prices may go up and down, the payment of dividends can provide comfort to the investor and more money to invest, for example to reinvest into more shares without risking money from other sources.
On the other hand, if owner managers do not need to take money out, then it may be best to keep the money in the company in order to reinvest at lower tax rates. However, you will still pay tax when you eventually take the money out or wind up the company.
What are the risks and disadvantages?
Paying the tax on dividends can be quite onerous. While salaries are an allowable expense which can be deducted from a company’s corporation tax liability, the same cannot be said about dividends.
Since dividends can only be paid out of profits, they are then subject to income tax (at the dividend rates) once in the hands of the shareholder. Dividends are not treated as ‘earnings’ for pension contribution purposes.
If you accidentally take a dividend that is not covered by profits, then there is a risk that you will have taken out a loan which must be repaid quickly.
If the company needs funds for future purposes or growth, then retaining money in the company can be sensible instead. Companies should factor in unexpected situations (for example, the Covid pandemic) and periods of low cash flow (may be seasonal or for other reasons) and whether paying out dividends will impact their ability to make a profit.
However, it is not a good idea to use a trading company as a ‘piggy bank’ as the cash will not qualify for business property relief from inheritance tax on death, unless it is being retained for a clear purpose.
Setting a pattern of paying dividends can lead to that income being expected and relied upon. In the unfortunate event of divorce, the family courts can take regular dividend income into account as a matrimonial resource.
Furthermore, investors that rely on regular dividends as their main source of income should be aware that companies can reduce the amount of dividends paid (or not pay them at all).
Those who apply for income-based support (which has seen more attention due to the Covid pandemic) cannot include dividends as part of their income.
Are there any circumstances in which dividends payments are not a good idea?
Although directors are under a duty to deliver shareholder value, this has to be balanced against practical considerations. An example is if a business is being sold, paying a large dividend could risk impacting the deal.
There are also instances where receiving dividend payments may not be a good idea, including:
- if you are going through a divorce or bankruptcy;
- if you are about to leave the UK to become non-resident, as it may be sensible to delay payment until you are non-longer UK tax resident; or
- if you are about to wind up the company then you could find that you benefit from a lower tax rate on liquidation (which can be liable to capital gains tax, not dividend tax), and potentially an ability to access business asset disposal relief at 10% for the first £1m of gains.
Dividend payments are just one way to extract money from a company – beneficial for some, but not for others. Given that taking money out of a company has a number of implications in the form of legal, tax and accounting, businesses should seek professional advice prior to making these decisions.