Lee Sharpe looks at the perennial question of how best to take reward from a family company.
While readers will be familiar with the maxim that dividends tend to be more tax-efficient than salary, more recent developments in corporate and dividend taxation will, in some cases, mean that a bonus can feasibly be more tax-efficient overall.
Background
There are two key developments in owner-managed business (OMB) taxation to keep in mind:
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Dividend ‘reform’ – In his summer 2015 Budget, the then-Chancellor set out a plan to put (or keep) the UK on a path to very low corporation tax rates (at least as low as 17%) as he was convinced that this would ultimately result in higher tax yields, as multi-nationals flocked to the UK to onshore their profits. But he decided he could not do this while there were such strong tax incentives “for people to self-incorporate and pay the lower rates of tax due on dividends.” So, dividends would thenceforth be taxed more heavily, while corporation tax was reduced ultimately to 19%.
Of course, small companies had been paying only 20% for many years so, in effect, Mr Osborne was making family company shareholders pay significantly more tax so that he could further subsidise large companies by reducing the main rate.
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Corporation tax volte face – More recently, the penny has dropped at HM Treasury that, actually, the UK is not drowning in corporation tax receipts despite the cuts to the main rate, so those cuts have been largely reversed to a heady 25% with a modest 19% rate for the first £50,000 of taxable profits, in most cases. However, note that there is a relatively punitive ‘marginal rate’ of 26.5% for those taxable profits falling above £50,000 and up to £250,000.
In terms of dividend taxation, the government has effectively doubled down on taxing dividends more heavily:
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The original £5,000 dividend nil rate band has been progressively whittled away, so that it is currently £1,000 but will be just £500 from April 2024.
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Likewise, the non-zero dividend rates were increased by 1.25% across the board so that shareholders did not feel left out of the Health and Social Care Levy when it was announced. But, while the levy was abandoned in late 2022, the dividend tax hike strangely remained. The levy would effectively have increased both primary (employee) and secondary (employer) social security contributions, so withdrawing the levy has made the salary route notably cheaper in comparison.
It could be said that we now have the worst of both worlds.
Crunching the numbers
We shall consider the traditional scenario of a singleton director or shareholder with profits of £50,000, including a pot of £30,000 to pay out; then a more nuanced scenario where the director or shareholder is already a higher-rate taxpayer from other sources, and the company is significantly more profitable.
In neither case will we assume that the director may utilise the employment allowance, given that it is not supposed to be available to companies where the payroll includes only the sole director. While the rules are relatively easy to circumvent, it is not something I would recommend as a policy.
This relatively common scenario sticks to the familiar playbook; the company and the director or shareholder are ‘protected’ by the ongoing 19% corporation tax rate for the first £50,000 of taxable profits, and the ordinary rate for dividends is still relatively modest.
If we turn now to the more complex scenario where both the company and the individual are exposed to the highest of the applicable tax rates, we start to see that increased dividend taxation is having an effect, compounded by the fact that salary will generally save corporation tax, affording more scope to pay relatively larger amounts.
In the second scenario, a bonus actually proves more tax-efficient than a dividend, by around £1,000.
Conclusion
OMB directors or shareholders and their advisers should be aware that the traditional rule of thumb that dividends are usually preferable is no longer as ‘safe’ as it used to be.
Where the company’s profits are exposed to the 25% main rate of corporation tax (or worse, the marginal rate of 26.5% for profits falling between £50,000 and £250,000 per annum) and particularly where the director or shareholder is already paying tax at higher or upper rates, with significant sources of income external to the company, it is possible that a bonus will prove relatively more efficient than has been the case for many years. The comparative savings may well be modest, but all the more precious in such straitened times.
Planning point
It follows that reward planning will need to be undertaken carefully and with due regard to the compliance implications of dividend and bonus payments.
