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Incorporation and the reduction in the Dividend Allowance

Mercia Blog Dividend Allowance

Traditionally the months of February and March allow us to catch up with clients to discuss pre-year-end tax planning. One area we may follow up with some clients is the issue about incorporating their business. There are many aspects to this of course, but clients may be particularly interested in the tax position.

The incorporation of a family business may be attractive with the corporate tax rate at 19% for FY 2018 (i.e. from 1 April 2018). The tax due on profits made within a company is less than the income tax payable on the same amount of profits made by a sole trader or partner. However, an individual will also have to pay Class 2 and Class 4 NI on his self-employed profits.

A reminder – Dividends

Dividends received by an individual are subject to special tax rates. For 2017/18 the first £5,000 of dividends are charged to tax at 0% (the Dividend Allowance). Dividends received above the allowance are taxed at the following rates:

  • 7.5% for basic rate taxpayers
  • 32.5% for higher rate taxpayers
  • 38.1% for additional rate taxpayers.

Dividends within the allowance still count towards an individual’s basic or higher rate band and so may affect the rate of tax paid on dividends above the £5,000 allowance.

To determine which tax band dividends fall into, dividends are treated as the last type of income to be taxed.

Reduction in the Dividend Allowance

The Dividend Allowance will be reduced from £5,000 to £2,000 from 6 April 2018.

The government expect that even with the reduction in the Dividend Allowance to £2,000, 80% of ‘general investors’ will pay no tax on their dividend income. However, the reduction in the allowance will affect family company shareholders who take dividends in excess of the £2,000 limit. The cost of the restriction in the allowance for basic rate taxpayers will be £225 increasing to £975 for higher rate taxpayers and £1,143 for additional rate taxpayers.  Even with this reduction incorporation is still attractive as demonstrated by the following example.

Incorporation v non-incorporation

Adrian and Sharon make annual profits of £100,000 as a partnership.  The year end is 31 March.

A comparison of their combined position as partners or if they incorporate, taking a salary equivalent to the nil rate NIC threshold (£8,424) and the balance as dividend, is as follows:

 2018/19

£

 2017/18

£

 Profits before salaries if incorporated  100,000  100,000
 Salaries 16,848 16,328
 Dividends if incorporated 67,354 67,774
 Taxes payable as follows:
 As partners  £ £
 Income tax  16,720  17,400
 NI  7,284  7,132
 Total =   24,004  24,532
 As company  £  £
 Income Tax on salaries  Nil  Nil
NI on salaries Nil Nil
Tax on dividends 4,236 3,832
Corporation Tax 15,798 15,898
Total =  20,034 19,730
Extra taxes payable if unincorporated  £ 3,970 £ 4,802

What effect does the 45% tax rate have on incorporations?

  • On these figures the incorporation route clearly gives a tax saving. In the example above it is assumed that Adrian and Sharon need to draw out all the after tax profits. Adrian and Sharon make annual profits of £400,000 as a partnership.  The year end is 31 March.
  • If the business needs finance, retention of profits to provide the finance is at the corporation tax rate rather than the income tax marginal rate if they remain as a partnership.

A comparison of their position as a sole trader or if they incorporate at the start of 2018/19 is:

 2018/19

£

 Profits before salaries if incorporated 400,000
 Salaries 16,848
 Dividends if incorporated 310,354
 Taxes payable as follows:
 As partners  £
 Income tax 151,200
 NI 13,284
 Total =  164,484
 As company  £
 Income Tax on salaries 3,368
NI on salaries Nil
Tax on dividends 89,046
Corporation Tax 72,798
Total =  165,212
Extra taxes payable if incorporated  £ 728

At this level of profits extra taxes are payable on incorporation if all the profits are distributed by way of dividend.

The more you store the more you save

If they are in the happy position of not needing all the profits to meet their expenditure then they should consider leaving some of the profits in the company.  Cut off points would be where income can be kept below £100,000 (thus retaining personal allowances) and £150,000 (thus not being charge additional rate tax).

If Adrian and Sharon have dividends such that additional rate tax is not payable this will give them each:

£
 Salary 8,424
Dividend 141,576

The taxes payable as a company now become:

 2018/19

£

 Profits before salaries if incorporated 400,000
 Salaries 16,848
 Dividends if incorporated 283,152
 Taxes payable as follows:
 As partners  £
 Income tax 151,200
 NI 13,284
 Total =  164,484
 As company  £
 Income Tax on salaries 3,368
NI on salaries Nil
Tax on dividends 78,684
Corporation Tax 72,798
Total =  154,850
Extra taxes payable if unincorporated  £ 9,634

The profits retained in the company can either be extracted in later years when income tax rates are lower or possibly extracted as a capital gain on a sale of the shares or liquidation of the company (but beware of the TAAR).

Written by Norman Allison

Norman Allison

Norman rejoined the tax team at Mercia after an absence of some 12 years. During this time he spent ten years with H&R Block Inc dealing with tax affairs of a wide range of clients and managing a national project with Barclay Banks as well as presenting throughout Eastern Europe. He was also a senior Tax Manager in the heart of the City dealing with the tax affairs for a number of high profile clients.

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