Postpone Paying Tax on Your Dividends
IF YOUR company is producing healthy profits, you may want to increase the amount of income you take as dividends.
In this article I will explain how you can postpone paying tax on your dividends by almost two years.
If your company is struggling because of the recession, and you are paying yourself no dividends or very low dividends, this article is still worth reading because, fingers crossed, your business will be in better shape next year!
The best way to explain how private company shareholders can postpone paying income tax on their dividends is with a detailed case study:
Case Study – Upping Dividends
Victor and his wife Ann are equal owners of Le Gourmand Ltd, a company that has built a reputation selling luxury imported foods to hotels, restaurants and delicatessens.
During the boom years the company made profits of approximately £300,000 per year. The couple extracted quite a lot of these profits as dividends but also kept a fair amount in the company, building a £200,000 cash buffer to tide them through any bad times.
The company’s profits fell dramatically in 2008 and 2009 and Ann and Victor only withdrew enough dividends to use up their tax-free basic-rate tax bands (around £33,000 each per year).
In the last 12 months the company has taken off again, thanks to Ann’s idea to start exporting caviar, truffles, and other luxury foods to Vietnam. The company is now sitting on a cash pile of £300,000.
During the forthcoming 2011/12 tax year, which starts on 6th April, Victor and Ann would like to withdraw around £150,000 of this cash as dividends (£75,000 each), plus a tax-free salary of £7,225 each.
The couple know they will have to pay income tax on some of their dividend income but they are very confident their business will continue to grow and generate even more cash, which they will eventually want to withdraw as well.
Although they could probably afford to withdraw even higher dividends, they want to keep a decent chunk of cash in the company to fund its Asian venture. They certainly don’t want to see their taxable incomes go over the dreaded £100,000 level, which would see their income tax personal allowances withdrawn.
The Company’s Cash
Victor is anxious to up their dividends as soon as possible because he is outraged at the paltry 1% interest the bank is paying on the company’s cash. With inflation running at 4% their hard-earned money is simply wasting away.
He wants to take a big chunk of the £150,000 dividend and invest it either in a rental property or shares.
In fact, Victor reckons he may be able to generate sufficient returns on the invested money to cover the income tax they will have to pay on their dividends.
The couple may even just take the low risk route and use the money taken out of the company to pay off some of the mortgage on their home (the bank is charging them 5% interest on that).
How Much Income Tax Will They Pay?
On 6th April 2011, the very first day of the new tax year, Ann and Victor declare and pay a dividend of £75,000 each.
£31,725 each of Ann and Victor’s dividends will be tax free.
The remaining £43,275 will be taxed at 25%, resulting in an income tax bill of £10,819 each – a combined tax bill of £21,638.
There are no other adverse tax consequences: we will assume that Victor and Ann’s other taxable income (from investments, savings, rental properties, etc) will not take them over the £100,000 level, which would see their personal allowances withdrawn, let alone the £150,000 level where 36.1% tax is payable on dividends.
Now for the important part:
Although tax of £21,638 is payable, the bill is not due until 31st January after the end of the tax year – i.e. 31st January 2013!
To recap, they pay themselves dividends on 6th April 2011 and the income tax is only due on 31st January 2013.
So, by paying themselves dividends at the very beginning of the tax year, Ann and Victor have managed to postpone their income tax bills by one year, nine months and 25 days. (That’s a devilishly superb total of 666 days.)
There is a saying in the tax advice business that the next best thing to avoiding tax altogether is deferring it.
The longer you can defer paying tax, the longer you have free use of your money, as we shall now see.
The Investment Strategy
To cover day-to-day living expenses, Ann and Victor have their small salaries and £31,725 each of their dividends – a total tax-free income of £77,900.
They decide to invest the taxable portion of their dividends – £86,550 – in a portfolio of undervalued stock market companies, and enjoy capital growth of 15% per year.
By 31st January 2013 – the due date for the income tax on their Le Gourmand dividends – they have enjoyed almost two years of capital growth and are sitting on gains of £25,254.
In summary, Ann and Victor have an income tax bill of £21,638 but, because the tax bill was deferred for 666 days, they have had time to invest the money and enjoy capital gains of £25,254.
The couple have completely covered their income tax bills and have an extra £3,616 in their pockets.
If Ann and Victor don’t have any other cash on hand on 31st January 2013 and have to sell some of the shares to pay the income tax on their dividends, it is likely that no capital gains tax will be payable – their gains will be completely covered by their annual CGT exemptions.
(Almost half the £86,550 taxable dividend could also have been invested in tax-free ISAs over the period.)
The Mortgage Strategy
Don’t you hate those patronising health and safety disclaimers that are pegged onto financial adverts: “Please remember the value of investments can go down as well as up and you may get back less than you invested…”?
Naturally Ann and Victor’s shares could have gone down instead of up. But we’re talking about a couple who have steered their business through one of the worst financial crises in history and gone on to build a successful operation in Asia.
They are not wet behind the ears and fully understand the risks.
Similar risks of capital loss would also be faced by taking the money and investing in rental property.
A lower risk alternative would be to use the £86,550 of taxable dividends to pay off the mortgage on their home. This would save them approximately £8,000 in mortgage interest. In other words, it would pay off around 37% of the income tax on their dividends.
In summary, if Ann and Victor pull off the higher-risk share investment strategy, they will completely cover the income tax payable on their dividends with money to spare.
With the lower-risk mortgage strategy, they will have to pay out around £13,638 (income tax less mortgage interest saved over almost two years).
However, that’s not a bad result when you stop to consider that their total income for the year is £164,450 – their effective tax rate is just 8%!