Avoiding Tax Thesholds
Tax Advantages of Being a Company Owner
Being a company owner has several tax advantages over being a sole trader or partnership.
- Less tax on profits extracted: Many company owners take a small salary and the rest of their income as dividends. This tax efficient mix often produces a tax bill many thousands of pounds lower than the tax paid by a sole trader/partner on identical profits.
- Further tax savings with spouse/partner: Many company owners make sure their spouses own shares in the business, even if they don’t work for the firm. This can produce savings if your spouse is taxed at a lower rate.
- Even less tax on profits reinvested: If some of the profits are retained within the company, the only tax paid is corporation tax, in many cases at just 20%.
There’s another advantage of being a company owner which is often overlooked but is equally important:
Company directors usually have complete control over their personal income tax bills.
Unlike sole traders, who pay tax each year on ALL the profits of the business, company owners usually only pay income tax on the money they decide to withdraw from the company.
This allows most company directors to reduce their income tax bills by adopting the following strategies:
- ‘Smooth income’
- ‘Volatile income’
With smooth income, the company owner withdraws roughly the same amount of money each year, even though the company’s profits may fluctuate considerably.
Smooth income allows the director to stay below any of the key income tax thresholds that result in higher income tax (see below).
With volatile income, the director takes a much bigger or smaller dividend than would normally be required to fund their lifestyle.
Volatile income could save you tax if:
- Tax rates are going up or down
- Your income falls into a lower tax bracket during some tax years.
- You want to avoid capital gains tax
- You intend to become non-resident
Company directors have to watch out for the following income tax thresholds:
- £42,475 Higher rate tax
- £50,000 Child benefit tax charge
- £100,000 Personal allowance withdrawal
- £150,000 Super rate tax
The last three thresholds didn’t even exist a few years ago, which goes to show how much more complicated and burdensome the UK’s income tax system has become for those considered to be ‘high income earners’.
These thresholds apply to your gross dividends, not the actual cash dividends you extract from your company. Gross dividends can be calculated by adding on the dividend tax credit of one ninth, or by dividing your cash dividends by 0.9.
In other words, if you want to avoid one of the above thresholds, your cash dividends divided by 0.9 (and your other taxable income) must be less than the relevant threshold.
Let’s take a closer look at some of these thresholds and the practical implications for company directors:
£42,475 – Higher Rate Tax
Owners of small companies (profits under £300,000) can withdraw the following ‘optimal’ amounts free of income tax in 2012/13:
- Salary - £7,605
- Cash dividend - £31,383
For owners of bigger companies (profits over £300,000), the best strategy generally is to take a salary of £8,105, and a £30,933 tax-free cash dividend.
In both scenarios, the salaries and gross dividends add up to £42,475: the threshold where higher rate tax kicks in.
When your taxable income exceeds £42,475, you start paying 25% income tax on any additional cash dividends you withdraw from your company.
If your household is not claiming any child benefit, the next income threshold you have to worry about is £100,000, where your income tax personal allowance starts to be withdrawn.
This means you can take additional cash dividends of up to £51,773 and the income tax charge on them will be just 25% (£100,000 - £42,475 = £57,525 x 0.9 = £51,773).
Generally speaking, you should only withdraw taxable dividends if you expect your company to continue producing ‘surplus’ profits in the years ahead.
There’s no point withdrawing £28,000 one year (tax free) and then £48,000 next year (partly taxed). It’s far better to pay yourself £38,000 tax free in both years.
This is what income smoothing is all about.
There are practical considerations, of course. For example, the company must have sufficient distributable profits.
Income smoothing is a bit counterintuitive because it may involve holding back dividends when the business is doing well and paying out more during lean years. Many company directors may find this difficult to do.
£50,000 to £60,000 – Child benefit tax charge
If you want to withdraw more than £42,475 from your company and your household receives child benefit, the next income tax bracket you have to watch out for is £50,000-£60,000, where the child benefit charge will be levied under current proposals.
Child benefit is worth £1,056 per year (tax free) if you have one child; £1,753 if you have two children; £2,449 if you have three; etc, etc. So, it’s definitely worth protecting.
For the current 2012/13 tax year, the best bet may be to follow the volatile income strategy and take a bigger than normal dividend.
For 2013/14 and future tax years, the following dividend strategies could be considered (figures quoted include gross dividends in each case):
Smooth income: If the income you withdraw is currently somewhere between the higher-rate threshold and £50,000, and you expect your income to continue growing, you should try to extract approximately £50,000 for several tax years. This may mean that you pay yourself more income than you need to begin with and less income than you need in later years, but you may be able to avoid the child benefit tax charge completely.
Volatile income: If you plan to withdraw over £60,000 from 2013/14 onwards, you should consider taking big dividends during some tax years and smaller ones in other tax years. For example, instead of taking £75,000 every year, take £100,000 every second year and £50,000 in the intervening years. This will allow you to avoid the child benefit charge every second year.
Austerity: If your taxable income is normally over £50,000, you could consider keeping your income below £50,000 for several years to avoid the child benefit charge. For example, let’s say you have three young children and your taxable income is normally £60,000. If for the next three years you can afford to withdraw just £50,000, you will protect £7,347 of child benefit.
£100,000 Personal allowance withdrawal
When your income goes over £100,000, your income tax personal allowance is gradually taken away. For 2012/13, once your income reaches £116,210, your personal allowance is completely withdrawn.
The personal allowance currently saves £3,242 in income tax, so what can be done to protect it? For most individuals, it’s a case of never extracting more than £100,000 in any one tax year (including gross dividends), even if your company occasionally enjoys bumper profits.
If your income is so high that you don’t enjoy any personal allowance, you could consider taking bigger dividends every second year and smaller dividends in the intervening years. This will save you £3,242 in tax every second year at current rates (rising to at least £4,000 by 2015/16).
Capital Gains Tax
It may also make sense to pay yourself lower than normal dividends in years in which you sell assets subject to capital gains tax: e.g. rental properties. This will allow you to free up some of your basic-rate band (£34,370 in 2012/13) and pay capital gains tax at just 18% on some of your capital gains.
If you intend to move abroad in the near future, you could consider paying yourself no more than the tax-free amounts listed above and extracting bigger dividends after you become non-resident.
Providing you move to a country that levies little or no income tax, this strategy could potentially save you an unlimited amount of tax. (Note, however, that under current proposals, you may need to ensure that you remain non-resident for at least five UK tax years for this strategy to work.)
Future Tax Changes
There are two income tax changes taking place in 2013/14 that could affect the amount of dividends you decide to withdraw during the current tax year:
- The child benefit charge
- The reduction in super tax
The Government is proposing to withdraw child benefit where any member of the household has over £50,000 income. This is being done by imposing an income tax charge on the highest earner in the household. Once the highest earner’s income reaches £60,000, all the child benefit will effectively be taken away.
The child benefit charge will only be levied in full from 2013/14, but a watered down version applies during the current tax year. Broadly speaking, the child benefit charge this year is one quarter what it will be next year.
For example, someone with £60,000 income will lose all their child benefit next year but only one quarter this year. Someone with £55,000 income will lose half their child benefit next year but just one eighth this year.
What are the implications for company directors? Those who expect to have income of more than £50,000 in 2013/14 should consider taking bigger dividends during the current 2012/13 tax year and a lower dividend in 2013/14.
The idea is to get your income below £60,000 (preferably no more than £50,000) in 2013/14, so that you avoid the child benefit charge partly or completely.
The reduction in super tax affects individuals with total income over £150,000. Their effective top tax rate on cash dividends will fall from 36.1% this year to 30.6% in 2013/14.
Where possible, company owners with income at this level should consider taking smaller dividends this year (to keep income under £150,000) and larger dividends in future years: when they will be taxed at a lower rate.
The tax advantages discussed throughout this article are not available to company owners who are unfortunate enough to be caught under the infamous ‘IR35’ rules (where the company’s income is deemed to be disguised employment income of the owner themselves). At present, these rules affect only a small minority of company owners but, under current Government proposals, their scope could be expanded considerably in the near future.