Watch out for new reforms to dividend taxation…

Following George Osborne’s announcement in the Summer Budget, find out what the dividend ‘tax allowance’ really means for small businesses...

The Summer Budget 2015 included plans to make major changes to the way that dividends are taxed from 6th April 2016.

For small business owners with a limited company that draw a small salary and rely on dividends, it’s important to note that from the 2016-17 financial year you will be taking less home.

Presently, small business owners that pay themselves using company dividends receive them net of a notional 10% tax credit. The result is that basic rate tax payers whose only or main source of income is the company dividends and a small salary, do not tend to pay any personal tax.

Dividends falling within the higher rate and additional rate bands are subject to tax at 32.5% and 37.5% respectively, but this is offset by the 10% tax credit.

Is it really a ‘tax allowance’?

However, chancellor George Osborne announced last week that this will change in a bid to close the loophole where businesses ‘pay’ their employees via dividends to avoid full income tax liabilities.

Mr Osborne has labelled it a new ‘tax allowance’, as every investor in a company – regardless of whether they are an employee or director – will have an annual tax-free dividend allowance of £5,000.

But there appears to be a sting in the tail. Small business owners who are top rate taxpayers currently have the ability to grow their business and pay themselves dividend income at an effective tax rate of 30.6%, or selling the company and paying capital gains tax at a rate of 28%.

From the 2016-17 financial year, the top rate of tax on dividend income will rise to 38.1%, while capital gains tax is set to remain at 28%.

The new dividend taxation system will reportedly recoup £6.8bn over this parliament in additional tax from small business owners and investors.

Winners and losers

The main beneficiaries of the new dividend tax system will be those whose dividend income is below £5,000, who will now pay no tax at all on their dividend income – a potential saving of £1,250 per year.

On the flip side, calculations suggest that a professional with no additional income who currently receives around £38,000 of dividend income tax-free will, from April 2016, face a tax bill in the region of £1,700.

The new rules will significantly have an impact on small business owners who choose to pay themselves an income in the form of dividends from their own companies – a strategy that the new rules have been designed to curb.

“There’s a very real possibility that the dividend taxation reforms will discourage entrepreneurism and certainly make sole traders think twice about taking the next step to trade as an limited company given the reductions in tax incentives to do so,” says Jo Nockels, senior training and communications manager, TaxAssist Accountants.

The Forum of Private Business (FPB) has expressed concern Mr Osborne’s dividend tax allowance will have a negative effect.

“Changes on how dividends are taxed may, in effect, be a tax on success,” the organisation said.

“Small business owners, who pay themselves last, are [going to be] left with a tax bill when they finally reward themselves for good company performance.”

Small business owners and entrepreneurs still unsure of their tax position following the Summer Budget 2015 are encouraged to seek professional advice. Accountants can offer tax planning advice and ensure tax affairs are structured to suit the needs of the taxpayers and in the most tax efficient way. When a change like the dividend taxation reforms is introduced, an accountant should be able to give you a rough idea of the impact on your tax bill, which is useful for cashflow and budgeting purposes.

TaxAssist Accountants is the UK’s largest network providing tax and accountancy advice and services specifically for small businesses.

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