This time last year, Phillip Hammond opened his big red briefcase and delivered some news that shocked small business owners across the country. Hidden among plans to increase ISA allowances and removing tax perks on buy-to-let properties, Mr Hammond revealed that from April 1st 2018, business owners who pay themselves in the form of dividends instead of salaries will see their tax-free allowance more than halved. Of course, many business owners promptly forgot about it in the face of more immediate challenges, but now the deadline is almost upon us, and it’s time to work out what exactly that cut means for you as a business owner.
What Exactly Will Happen?
Every year, individuals are allowed to receive a certain amount of dividend income as ‘tax free’, meaning they don’t pay any tax on it. This applies to dividends in any form, so it also covers investment dividends, or dividends on property portfolios, for example. Prior to April 2016, providing your total income fell below the higher rate tax threshold there would be no income tax to pay on any dividends, but this changed with the introduction of the dividend tax.
But now, the tax-free allowance is being slashed. This means that the directors of small businesses can only draw out £2,000 of dividends tax free. Beyond that, anything drawn from £2,001 up to £27,000 will be taxed at the basic-rate of 7.5%, with anything above that amount being taxed at the 32.5% rate for higher tax payers. According to the Government data, this change will impact around 2,27 million individuals, with the average tax bill going up £315 per year.
How Will It Work?
It can sometimes be difficult to picture exactly how such changes will affect you overall. So picture this scenario:
Say you are a company director receiving a salary of £10,000 and you are awarded £40,000 in dividends every year. You have no other income.
2015/2016 tax year – A tax bill of £2,575 would have been payable on a salary of £10,000 and dividends of £40,000.
2016/2017 tax year – £1,000 of the dividends would be tax free due to the increased income tax threshold of £11,000, and a further £5,000 would be tax free due to the dividend allowance. So the dividend amount of £27,000 (which taxes you up to the higher tax threshold) would be taxed at 7.5%, and the remaining £7,000 would be taxed at 32.5%. That makes the total tax liability due £4,300.
2017-2018 tax year – The personal tax allowance was increased to £11,500, and the higher rate threshold was also increased to £45,000. Here, your personal tax liability would reduce by £150 in 2017/18 versus the previous year.
2018/2019 tax year – So we come to where we will be on April 1st. In this scenario, the reduction in the dividend allowance from £5000 to £2000 would lead to an increase in personal tax liability of £975 versus 2017/2018. This is because the reduction in the dividend allowance means that an extra £3000 would be taxed at the higher rate of 32.5%.
Can I Get Around It?
Unfortunately, not really. The cut was designed to bring the taxation rules for self-employed people and small business owners in line with the rules for traditional employees. The move effectively closes a loophole that millions of small business owners had been enjoying for years, allowing them to see more return on their hard work. So the most advice we can give is to speak to your accountant now, and see if you can bring forward some dividend payments so that you can take advantage of the allowance before it’s cut.
At Cove Accountancy Services, we work with small business owners to understand their tax liability, and how they can utilise the rules for small businesses to get the most out of their business. If you would like some advice about running your dividend based business after these cuts, or just want to ask us a question about the new threshold, please just get in touch with us today.