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Salary or Dividend?

The impact of new tax legislation relating to dividend income on owners of SME’s

Until now the most business efficient way of extracting company profits is by its direct-shareholder was to draw a minimal salary and have the cash flow flexibility to draw dividend’s (assuming availability of reserves)

For most owner managed businesses this meant that the salary was set at the personal allowance of £10,600 (2015/16) or up to the NI threshold of £8,059 (2015/16). Most tax conscious directors reluctant to go into the 40% tax rate typically paid themselves a dividend up to the basic tax rate, thus drawing total cash of £35,060 without incurring any personal tax or NIC

From 6th April 2015 tax rates applied to a dividend income will change considerably

In summary:

  • The effect of the change is that any distribution of profits over £5,000 will now be taxed

  • An equivalent scenario of a salary below tax and NI thresholds and a dividend up the basic tax rate, will now cost £1,429 in dividend tax

  • Tax free income is reduced from £35,060 in 2015/16 (min salary of £8,060 plus next tax free dividend of £27,000) to only £16,000 in 2016/17 (personal allowance + dividend tax free allowance).

The change in legislation effectively means that from 2016/17 the following will apply in an income tax computation:

  • A 0% band of £5,000 applied to dividend income. This allowance reduces the basic tax rate band, rather than being applied in addition to it

  • Up to basic band rate 7.5%

  • Higher rate: 32.5%

  • Additional rate: 38.1%

  • Dividend tax credit will no longer apply

  • Dividend income in the tax computation will not be grossed up

Two examples will illustrate the differences between the current and 2016/17 tax computations relating to remuneration drawn as a combination of salary and dividend

These examples aim to provide only a very simple illustration of the mechanics of a personal tax calculation, the tax cost and net funds available to an owner of a small business. The illustrations do not address the issue of the cost of extracting profits at the respective levels mentioned in the scenarios to the company, as their aspect remains unaffected by the new legislation

Illustrative Example 1

Director-Shareholder takes a salary of £31,000 and a net dividend of £27,000 (gross £30,000)

The new dividend tax will cost the director-shareholder an additional £1,132 in tax in 2016/17, in comparison to what he would have paid in 2015/16

Illustrative Example 2

Director is a higher rate tax payer and takes small salary up to the level of personal allowance and £80,000 net dividend

In 2016/17 the direct-shareholder will pay £4,777 more in dividend tax as a result of the legislative changes

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