Select Page

Tax isn’t the easiest of subjects to get your head around. And, just as you do, they change the rules. This article aims to help you understand the implications of the new rules. While it may not be great news, we feel that it’s important.

Popular Capitalism?

Nowadays all kinds of people run their own businesses. Not just contractors and entrepreneurs. But also taxi drivers, hairdressers and even doctors.

The recent announcements in the Summer Budget 2015, which come into effect in April 2016, are pretty lousy for these types of small or one-person businesses.

Until now, tax experts usually suggest that freelancers who earn profits above a certain level would save tax, or be more tax efficient, by trading as a company rather than as a sole trader.

But due to the changes, from April 2016, our opportunities to be tax efficient are being squeezed, as the differences between these two choices become less distinct.

Let’s explain…

Paying ourselves first

Currently, if you trade as a company and pay yourself a small salary plus dividends, you would pay little or no personal tax.

Your salary is usually set below the threshold (currently £10,600) and you don’t have to pay any personal tax on your dividends if your taxable income is below the basic rate tax threshold of £42,385.

Further profits or savings are usually retained in the company, which allows us to have a safety net for those less profitable months.

Profits mean prizes

Dividends to shareholders (you) are deemed to have been paid with 10% tax already deducted.

For example, a £28,350 dividend is treated as a gross dividend payment of £31,500. You can check this out by doing the calculation of £31,500 less 10% of £31,500 and find that this equals £28,350.

So, if you pay yourself dividends of £28,350 (£31,500 gross) on top of a £10,600 salary, you would be just below the £42,385 threshold and pay no tax.

With us so far?

Taxman’s taken all my dough…

From April 2016, they’re getting rid of this 10% tax credit and instead making the first £5,000 of your dividend payments tax-free.

Then, tax will be calculated at the rates of 7.5%, 32.5% or 38.1% (depending on your rate of tax) on all dividends above that amount.

This means, using the same example above, if you pay yourself dividends of £28,350 the first £5,000 would be tax-free, but you would pay 7.5% dividend tax on the remaining £23,350 (£1,751.25).

With the 10% tax credit now gone, you’ll be allowed to pay yourself £31,500 in dividends, instead of £28,350, and still stay within the lower rate tax threshold (using 2015/16 levels). But this would increase your tax bill to £1,987.50.

That’s nearly £2,000 extra in tax – which is not an insignificant sum! 

Also, as your company will have already paid corporation tax on profits, it feels like paying tax twice.

Sidenote for higher rate taxpayers:

Those whose gross dividend plus salary combination exceeds that £42,385 figure – will also pay more tax, though not such a significant difference as basic rate taxpayers.

An extra dividend payment of £10,000, say, above taxable income of £42,385 would incur £3,250 extra tax instead of £2,500 as it stands currently. Still not an insignificant amount.

Other changes worth considering.

1. Since April 2014, employers have been able to reduce the amount of National Insurance contributions (NICs) they pay for their employees by up to £2,000. But if you’re the sole employee of your own limited company, from April 2016 you’ll no longer be able to claim this £2,000 NIC Employment Allowance.

2. From April 2016, you’ll no longer be able to claim tax relief on travel and subsistence expenses, which may increase your taxable profits.

What can we do about this?

Talk to your accountant about how these changes effect you and whether it’s still right for you to trade as a Limited Company. And ask what they suggest about the right balance between salary and dividends from April 2016.

(Or you could run for government, which, unless you have enough retained profits, we wouldn’t advise).

Don’t forget that minimising tax isn’t the only factor to consider when choosing between operating as a sole trader or Limited Company. You may want to run a company to benefit from added protection of liability of your own assets in case the business is sued. Or add to your professional credibility by trading as a company.

Closing thoughts

Whilst we clearly understand the need for tax, scrapping the old dividend system in favour of this new one will significantly hit those of us trying to help the economy. Those of us willing to put in the extra effort and take the necessary risks by building a business. Is that fair? We don’t think so.

If you want more like this? Be sure to sign up for our latest content.

 

PLUS - Gain access to our FREE my-money-fitness spreadsheet.

 

Join Our Community. No spam, ever. Unsubscribe anytime.

 

Awesome, please check your inbox for our confirmation email.