What’s Your Remuneration Strategy For 2018?

Alan Pink looks at the tax impact of different methods of profit extraction in the current tax planning environment.

To many people, it’s obvious that running your business through a limited company must save you tax. After all, the corporation tax rate is only 19%, whereas a sole trader or person carrying on a business in partnership is taxable at rates of up to 45%, plus Class 4 National Insurance contributions (NICs), on the top slice of their income. 

So surely, the argument runs, for businesses which are bringing home anything more than the basic rate tax allowance of (all together) just over £40,000 per person shouldn’t hesitate before incorporating their business. Under the proposals announced in Autumn Budget 2017, the basic rate threshold, at which 20% tax turns into 40%, actually occurs at just over £46,000 per person.

The problem with this simplistic view is that the money needs to be drawn out of the company again; and the two usual ways of doing this are by paying yourself director’s remuneration or dividends on the shareholdings you have in your company. 

The goalposts have moved rather since what might be termed the ‘classic era’ of tax planning, where dividends were paid out of profits of the company which had borne corporation tax, that is they came out ‘below the line’ and were not allowable expenses; but carried with them a ‘tax credit’, which was effectively equivalent to a credit for the underlying corporation tax. Dividends were clearly preferable to remuneration in terms of the amount the individual was left with at the end of the day because, unlike remuneration, dividends don’t carry with them a liability to NICs. 

This is still basically the case, of course. NICs are at a rate of 13.8% for the employer, and 12% for the employee (going down to 2% over about £40,000 of remuneration). 

What has moved, though, is the treatment of dividends. These no longer carry the so-called ‘tax credit’, which in any event had become fairly mythical in recent years, after Gordon Brown abolished the ability to reclaim them. The tax credit being abolished, Mr Osborne (yes, it’s him again!) took the opportunity of sneaking in an effective extra 7.5% or so tax on those receiving dividends. So, whereas the position used to be that a basic rate taxpayer, receiving a dividend which in itself did take him above the 40% threshold, had absolutely no tax to pay, he now has 7.5% to pay over a limit which has been reduced, with effect from 6 April 2018, from £5,000 to £2,000.

Somebody who is in what would otherwise be the 40% band of income tax now pays 32.5% rather than the 25% effective rate he paid before; and finally, somebody in the top rate of tax, that is whose income is more than £150,000 for the year, now pays 38.1% on the net amount of the dividend. 

Where does this leave planning for paying remuneration or dividends? In my view, it will almost always leave it in pretty much the same place, because the 7.5% extra dividend tax, so to call it, has been set at a level (I suspect deliberately) where it is still preferable, just about, to pay dividends. 

This is because the 7.5% ‘surcharge’ is likely to be less than the NICs burden of paying remuneration, and this is still the case even in the new environment. 

What the change to dividend taxation does do, however, is lend a new importance to alternative ways, leaving aside the classic remuneration/dividend choice, of extracting income from the company. 

For example, if the company uses your own premises to any extent for its business, there is nothing stopping it paying a commercial rent for doing so. Rent, like remuneration, is an allowable expense against the profits of the company and therefore reduces its corporation tax. Also, like remuneration, it is chargeable to income tax on you as the individual recipient. However, it differs from remuneration in the all-important fact that it doesn’t bring with it any associated NICs liability. You will note that this also places it above the dividend option in normal cases where the dividend tax would apply. 

Like rent, interest paid on any employee or director’s loan to the company is an allowable deduction against corporation tax and is chargeable to income tax but not NICs on the recipient. Interest also carries with it an exemption for the first £1,000 received. 

Moving on to more ambitious planning, it’s sometimes possible to take money out of a company in capital rather than income form. 

For example, let’s suppose you have an asset, like computer software that you have written personally and belongs to you personally, which you can transfer to the company. It’s likely that this transfer will trigger a capital gains tax liability on you because you probably won’t have any base cost to offset against what the company pays you. However, under current rules, this capital gains tax will be no more than 20%, even if you are a top rate income taxpayer. Moreover, certain types of assets of this kind are subject to the ability of the company to claim tax relief for what it is paying you by writing it off against profit and loss in annual tranches. 

As always in this sort of comparison, there’s no substitute for doing the sums in a particular instance. Supposing that your only available practical options are dividends and remuneration, it’s likely that dividends will leave you with more money in your pocket at the end of the day. However, there are cases where this rule doesn’t apply, for example, where you have the ability to make pension contributions which can be offset against earned income like remuneration, but not against unearned income like dividends. 

Very often, the position isn’t a binary one between remuneration and dividends, of course. It’s almost standard practice, and I think will continue to be next year, to pay a comparatively small amount of remuneration with the balance in dividends, so that sufficient earned income is triggered to make the year count for NICs purposes.

Here is one piece of lateral thinking which might even be considered completely ‘off the wall’. If you think about it, where you conduct your business through a limited company and pay all of its income out to yourself as dividends, you’re actually paying more tax overall than if you simply ran the business as a sole trader, a partner in an unincorporated partnership, or a member of a limited liability partnership. Let’s take an example to prove this. We’ll assume that Mr A is in the top rate of income tax, that is he pays 45% on most types of income and 38.1% on dividends. If he runs his business through a company, and this pays 19% corporation tax, there’s then 81% of the profits left to pay out as a dividend. 

Once you’ve taken 38.1% of this away and paid that to HMRC too, you’re actually left with just a whisker over 50% of your profits post all tax. The top rate taxpayer receiving income direct from the trade in the form of sole tradership or partnership, however, pays 45% plus, in most cases, a 2% Class 4 NICs charge, making a total of 47%. Therefore, the company has added an extra layer of tax of nearly 3% simply by having been put in the way between Mr A and his business.