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As we enter the final months of the 2020/21 tax year, family companies should renew their profit extraction policy and consider whether they can and should pay further dividends before the end of the tax year.
Reminder: How dividends are taxed
Dividends can only be paid out of retained profits and thus, unlike payments of bonuses or salary, the amount that can be extracted from the company as dividends is capped at the level of the company’s retained profits. Even if due to the Covid-19 pandemic a profit has not been made this year, the company still pay dividends if it had retained profits brought forward and these have not been eliminated by any current year loss.
Retained profits profits after corporation tax has been paid and thus they have already suffered tax in the hands of the company. For the 2020 financial year (i.e. running from 1 April 2020 to 31 March 2021), the corporation tax rate is 19%.
Once retained profits have been paid out as a dividend, they represent taxable income in the hands of the recipient. Consequently, the profits are taxed again. This may not be as bad as it sounds, as the combined effect of corporation tax already paid on the profits, plus the dividend tax on the dividend, may be less than the income tax and National Insurance contributions (NICs) that would be payable on profits paid out as salary or bonus, despite the fact that salary and bonus payments and the associated employers’ NICs are deductible in computing the family company’s taxable profits. Unlike salary and bonus payments, there are no NICs to pay on dividends.
In the hands of the shareholder, dividends are treated as the top slice of income and taxed at the appropriate dividend rate of tax. The dividend tax rates are lower than the income tax rates, allowing for the fact that corporation tax has already been paid. Dividends not covered by the dividend allowance or any available personal allowance are taxed at 7.5% to the extent that they fall within the basic rate band, at 32.5% to the extent that they fall within the higher rate band, and at 38.1% to the extent that they fall in the additional rate band.
However, that is not the end of the story – all taxpayers, irrespective of the rate at which they pay tax, are entitled to a dividend ‘allowance’ (£2,000 for 2020/21). The ‘allowance’ is really a nil rate band rather than a true allowance in that dividends which are covered by the allowance form part of band earnings. Dividends sheltered by the dividend allowance are taxed at a rate of 0% rather than at the relevant dividend rate. The dividend allowance is a useful tool in the family company tax planning toolbox.
Remember your ABCs!
When paying dividends, company law rules must be adhered to.. As well as restricting the amount of dividends that can be paid out to the level of the company’s retained profits, to comply with company law requirements, dividends must be paid in proportion to shareholdings.
For example, if a family company has 100 ordinary shares, of which 60 are owned by Mr A, 30 are owned by Mrs A, and 10 are owned by Miss A, and the company has £10,000 of retained profits which it wishes to pay out as a dividend, it must pay a dividend of £6,000 (60%) to Mr A, a dividend of £3,000 (30%) to Mrs A, and a dividend of £1,000 (10%) to Miss A. This may not be ideal from a tax planning perspective; if Mr A is a higher rate taxpayer and Mrs A is a basic rate taxpayer, it would be more tax-efficient to pay a higher dividend to Mrs A.
However, while the necessity to pay dividends in proportion to the shareholding may look like a problem in ensuring the tax-efficient extraction of profits, it is one that can be avoided by having an ‘alphabet’ share structure. This simply means having a different class of share for each shareholder; for example, ‘A’ class ordinary shares for Mr A, ‘B’ class ordinary shares for Mrs A, and ‘C’ class ordinary shares for Miss A. Different dividends can be declared for different classes of share, providing the flexibility to tailor dividend payments to the circumstances of the recipient to ensure that dividends can be paid out in a tax-efficient manner.
As the end of the tax year approaches, family companies are advised to undertake a review so that they can decide whether it is desirable to extract profits from the company before the end of the tax year. If there are profits to be extracted, the company must decide how the profits should be extracted and who they should be paid to.
In order to answer these questions, it is not only necessary to establish what profits are likely to be available for extraction, but also what other income the family members have, whether their personal allowance and/or dividend allowance remains available and whether they have used up all of their basic or higher rate bands.
As a starting point, it is generally tax-efficient to pay a small salary and to extract further profits as dividends. Assuming the recipient’s personal allowance is available, the optimal salary is equal to the primary threshold for Class 1 NICs purposes (£9,500 for 2020/21) where the employment allowance is not available. For 2020/21, the primary and the secondary NIC thresholds are not the same and while paying a salary equal to the higher primary threshold means that a small amount of employer’s National Insurance is payable, this is more than offset by the corresponding corporation tax reduction. If the employment allowance is available, the optimal salary is equal to the personal allowance (assuming that this is not used elsewhere), set at £12,500 for 2020/21. Above this level, it is generally more efficient to extract profits as dividends. Before paying out dividends, consider whether the optimal salary has been paid.
However, it should not be forgotten that there are other options for extracting profits, such as rent where the business is operated from a room in the family home, benefits-in-kind, pension payments etc.;when planning a profit extraction policy, it is advisable to look at the bigger picture.
Smith Ltd is a family company. Mr and Mrs Smith are both directors. The employment allowance is available and Mr and Mrs Smith each receive a salary of £12,500, equal to their personal allowance for 2020/21. Mr Smith also receives rental income of £45,000 from property, which he holds in his sole name.
Mr and Mrs Smith have two grown-up daughters – Catherine and Dawn. Catherine works part-time as a classroom assistant earning £6,000 a year. Dawn is a lawyer earning £250,000.
All family members are shareholders. Mr Smith holds 100 ‘A’ ordinary shares, Mrs Smith holds 100 ‘B’ ordinary shares, Catherine holds 100 ‘C’ ordinary shares and Dawn holds 100 ‘D’ ordinary shares. None of them has used their dividend allowance.
The company has retained profits of £50,000 which they are considering of extracting in the 2020/21 tax year and want to extract profits in a tax-efficient manner.
The starting point is to look at what income each family member has. Salaries have already been paid at an optimal level to Mr and Mrs Smith. Their daughters do not work in the business.
As all family members have shares they can all receive dividends. The alphabet share structure provides the flexibility to tailor dividend payments to allow the profits to be extracted in a tax-efficient manner.
Each family member has their dividend allowance available. The starting point is, therefore, to pay a dividend of £2,000 to each family member – using up £8,000 of the retained profits. No further tax is payable, as in each case the dividends are sheltered by the dividend allowance.
Catherine has only used £6,000 of her personal allowance, leaving £6,500 available. Paying Catherine a dividend of £6,500 will enable a further £6,500 of profits to be extracted tax-free.
Thus, the company can extract £14,500 of profits without paying any further tax. Beyond this level, tax is payable; to minimise the overall liability, the starting point is to use any available basic rate band. Both Mrs Smith and Catherine have only used £2,000 of their basic rate band (dividends are sheltered by the allowance), leaving £35,500 available each. As the retained profits remaining are £35,500, they can be paid to either Mrs Smith or Catherine (or split between them in such proportion as may be agreed) while keeping the liability to the basic rate (a total tax bill of £2,662.50, being £35,500 @ 7.5%). If these dividends were paid to Mr Smith, they would be taxed at 32.5% and if they were paid to Dawn, they would be taxed at 38.1%.
By taking account of the personal circumstances of each family member, it is possible to extract profits from the company while minimising the overall tax bill.
Undertake a review prior to the year end to determine whether it is advisable to pay dividends before the end of the tax year and, if so, to whom.