Dividend Tax Changes — Minimising the Effect
For most independent contractors, the preferred business model is to operate through a private limited company. Not only does that give the benefits of a more professional image and limited liability, it also is the most tax-efficient option.
The latter has generally been the most important point for contractors because it results in a consistently higher net income. By adopting a low salary/high dividend remuneration strategy, contractors have been able to avoid excessive NI contributions (both employer’s and employee’s) and reduce their overall tax charge.
That strategy has been called into question since the 2015 summer budget, which introduced changes to the way dividend payments are taxed. Rather than applying a 10% tax credit that means basic rate taxpayers could receive just over £38,000 in dividends tax free, there’s now a £5,000 dividend allowance and increasing rates of tax above that level. These charges depend on your tax band, starting at 7.5% for the basic rate and rising to 38.1% for additional rate taxpayers. Yes, the contractor suffers again …
The changes were reportedly brought in to encourage small investors to invest but have caused potential problems for contractors relying on dividend income. Anyone taking £80,000 in dividends annually could be almost £5,000 worse off. Consequently, many are now undecided as to how best to structure their business for the most tax-efficient operation.
Actions to Take
Up to the start of the current tax year, there was the option to bring forward the payment of dividends to avoid the new tax regulations. However, that opportunity has now passed, was fraught with dangers that included the loss of personal allowances and taxation in higher bands, and depended on the availability of sufficient cash in the business.
There are still the basic considerations that apply to any taxpayer. These include utilising fully your personal allowance, tax bands and the new tax free dividend allowance, both for yourself and your spouse or partner (if they are legitimately working in the business). You should also make full use of ISAs and SIPPS for your investments as well as making maximum contributions into pension funds to reduce tax liabilities and, at the same time, prepare for your future.
More specifically for contractors, ensure you charge the business for the full use of your home or other property, claim all allowable expenses and charge interest on any director’s loan account balance. If, however, you feel the effect of the changes added to the extra effort and cost of running a limited company make it no longer worthwhile, you may consider closing the company and reverting to sole trader status.
Nevertheless, although most contractors will be left worse off, payment by dividends rather than salary alone is generally still the best option due to the high cost of employer’s and employee’s NI contributions. The preferred course of action is to model the tax effects of the different payment methods before taking a decision. That’s best done with the help of a specialist, such as Phoenix Cloud Accounting, which has all the tools necessary to help you. Phoenix currently offers and unbelievable deal: try them out for 60 days free of charge!