As we enter the final months of the 2019/20 tax year, family companies should renew their profit extraction policy and consider whether it is tax-efficient to pay dividends before 6 April 2020.
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.
Retained profits are broadly profits on which corporation tax has been paid and thus they have already suffered tax in the hands of the company. For the 2019 financial year (i.e. running from 1 April 2019 to 31 March 2020), 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, despite the fact that salary payments and 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 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, all taxpayers, irrespective of the rate at which they pay tax are entitled to a dividend ‘allowance’ (£2,000 for 2019/20). 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!
Dividends come with company law rules, which 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, if 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 should 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 (£8,632 for 2019/20) where the employment allowance is not available. 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 2019/20. 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.