ebrief for freelancers and contractors Combining salary with dividends

Transcription

1 ebrief for freelancers and contractors Combining salary with dividends

2 Efficiently combine salary with dividends and declare your dividends at a time that suits you. At Intouch Accounting, the personal online accounting adviser for contractors and freelancers, we discuss how contractors legitimately reduce their overall taxation costs by efficiently combining an annual salary with any additional cash requirements being taken as dividends from the company. Payment dates for tax on dividends should also influence the date dividends are declared. One of the benefits of trading as a contractor through a Limited Company is the flexibility that results from this ability to combine a base level of salary with dividend payments in a tax effective way. Designed to maximise your take home pay: Keep what s yours and only pay the taxman what s rightfully his. If your contracting business in year one is expected to bill fees of 50,000, incur net expenses (ignoring director s salary) of 5,000 leaving a profit (surplus) before tax and director s salary of 45,000 then what can you do to minimise your overall tax liabilities? What salary should you pay yourself? ( Nil, High, Low) What s the difference Should you declare dividends? (Yes, No, How much?) When should you declare dividends? Which actions are provocative to HMRC? Should I be the only shareholder? (Yes, No, It depends) How do you decide? Understand the rules of the game When a contractor wants to take money from their business other than when taking a loan, reimbursing expenses, or when they are closing the business down, it must be taken as a salary or a dividend. Salaries can be paid to any employee but dividends can only be paid to shareholders. Contractors using personal service companies are often both employees and shareholders and for this reason they can enjoy the flexibility of choosing how to take their money out. This tax guide will only try to answer some of your questions and to put the issues into perspective. We can explain the rules, the advantages and the risks. To get the best answer (which is the right answer for you) it must be based on personal circumstances and your attitude to risk. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 1 2

3 A carefully thought out share structure can also reduce the amount of overall tax payable but this level of planning requires a detailed review of your personal circumstances. So read on and ensure you are not missing out on the tax saving opportunities available to you First things first: What is a salary? Salaries paid to the director(s) who are often also the main shareholder(s). When a salary is paid to any employee it is as a reward for their services as an employee and is not in anyway linked to being a reward as a shareholder. In most circumstances, salaries are set at an annual level approved by the directors and can range from nil to any commercial upper level agreed for the work performed, and one which can be supported by the business. Salaries are an allowable expense of the business and are deducted before corporation tax is calculated (in other words they get tax relief). Above certain levels salaries attract employee s and employer s National Insurance contributions, as well as an income tax liability in the hands of the employee. Take advice before you determine the most appropriate level of remuneration-there are some further details and quirks outside the scope of this tax guide Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 2 3

4 Choices in which level of salary to pay Some directors choose to pay themselves a salary of Nil and take all of their earnings from the business as dividends. As a consequence they pay no National Insurance at all, but this does have other implications to be considered. Paying no National Insurance in a tax year may reduce a future entitlement to any state pension and some state benefits Salary is associated with the maximum tax allowable value of personal pension contributions but the company pension contributions are not restricted by the salary HMRC may interpret not being paid for the services as an employee as aggressive and argue that dividends paid or declared incorrectly may indeed be salary in disguise and seek to tax them as salary. What happens in practice? Many directors choose to pay themselves a basic salary up to the limit when National Insurance contributions become payable. For the tax year 2013/2014 this lower threshold is 7,696 pa (called the secondary threshold) for employer s National Insurance and 7,755 pa (called the Primary threshold) for employee s National Insurance. For simplicity and so ensure no contributions are due many directors opt for the lower secondary threshold level of 7,696 pa as their minimum salary. (Although at this level no National Insurance is payable, a credit for notional contributions is given for state pension and benefit purposes.) However, whilst choosing the level of salary to be paid is a personal decision of the director, remuneration at the National Insurance threshold is lower than the National Minimum wage. From 1 October 2013 the National Minimum Wage for persons over 21 years of age is 6.31 per hour. Which at 35 hours a week, 52 weeks a year, generates an approximation of the annual minimum wage of 11,500. Many commentators and advisers suggest salary at this level as a sensible alternative to levels below the National Insurance threshold as it demonstrates an intention to operate a genuine commercial business. Directors may choose to take a salary above the National Minimum Wage to support either a mortgage or loan application or for other personal reasons. There is no tax benefit for contractors in taking salary in excess of this level except in the case of special circumstances. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 3 4

5 What are the rates of National Insurance if your salary is above the threshold? Above the minimum annual thresholds National Insurance contributions are due from both the employer and the employee at the following rates. Class 1 Employers: National Insurance is paid at a rate of 13.8% of the gross salary for all earnings above the Secondary threshold of 7696 pa. Class 1 Employees: National Insurance is paid at a rate of 12.0% on earnings between 7,755 and 41,450 (i.e. on the band of 33,695= 4,043.40). For any earnings above 41,450 in 2013/2014 the rate payable is reduced to 2%. Therefore, you can appreciate that there is a balance to be found between paying remuneration as salary which (above the minimum levels) attracts National Insurance contributions, and additional cash being paid out to shareholders in the form of dividends, which do not attract any National Insurance contributions. There are other differences between these choices that should be considered, that are not as visible as the tax effect. Your accountant will be able to answer your questions. National Insurance paid by the employer is also deducted before a company s corporation tax liability is calculated and will therefore get tax relief Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 54

6 Before we start to explain the advantages of dividends, which help make limited companies much more attractive than Umbrella solutions, where the only payment option is a salary. Let us explain some basic concepts and build up to consider what a dividend is and who can receive them. What is a dividend? Dividends are basically payments made to the owners of the company (the shareholders) from the company s accumulated profits after corporation tax (In other words income less expenses and salaries, and also after deducting corporation tax). Each year the business trades if it makes a profit (or surplus) after corporation tax, then this remains within the company where, together with surpluses from all earlier years it accumulates. It can be reduced by losses made in any year or reduced as a result of some other technical reasons, but otherwise it just keeps growing until: either the shareholder/directors decide to declare a dividend, or the business is closed and the contracting trade ceases when it will be repaid to the shareholders. A dividend becomes payable to the shareholders when the directors decide that a dividend should be declared, and it is payable to the shareholders directly in proportion to the shares that each owns. So, if you wanted to pay a dividend to someone who doesn t hold shares in the company you can t...! When you set up your company you may not have realised that ownership of shares is so important and that it would have a major effect on how and who can receive money. It s often overlooked, unless you have the advice of an accountant, or you considered it when you incorporated your own company. But, don t worry If you have not yet considered the shareholding in your company, it s not too late. And, in turn, if no profit has been accumulated and retained in the business in the period since commencement, then the company cannot pay a dividend. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 5 6

7 Dividend tax voucher Once the dividend has been declared and the due payment date agreed, the company should issue to the shareholder a voucher that details the amount of dividend per share, the number of shares held and the total amount payable, together with the amount of the tax credit which is the amount of tax treated as if it was paid at source What ways are there to get money out of the company? Company money does not belong to you until you become entitled to it. You become entitled to receive money, because of a relationship with the company, which can be categorised as follows: 1. Management (your directorship), 2. Employment (your services as a worker), and 3. Ownership (your shareholding) It s important to understand that each relationship is separate and that each one can independently establish an entitlement to receive money from the company. If we ignore reimbursement of expenses and loans made to or from the company (which are considered in detail in other topical monthly guides and ebriefs published by Intouch) then we are left with three main ways you become entitled to receive money from the company: 1. As a salary or fees payable for your directorship, or 2. As a salary for your employment, and 3. As a dividend receivable as a shareholder. Options 1 and 2 above are rewards for your employment services and are very different from option 3. Any dividend entitlement only arises because of a shareholding in the company and has nothing to do with employment or services provided. The way you pay yourself can take several forms to ensure you keep more of what you are entitled to. Subscribe to our mailing list and see other useful guides for free Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 6 7

8 Why is Profit after tax an important figure? Accumulated profits and losses since the business began When a company declares a dividend, it can only do so if there are sufficient available profits at that time. You, as director, are responsible for making sure that there are sufficient profits and for remembering that profits for dividend purposes are always calculated after provision or deduction of corporation tax; so it s necessary to have some form of up to date management accounts to work out the profits available when you are thinking of declaring a dividend. You don t have to pay dividends in the year that the profits are made. The maximum amount that can be paid out as a dividend is a running balance of the accumulated profits (less any accumulated losses), less the accumulated dividends previously paid, from the date the Company started. Example In Year 1 your company made profits after tax of 20,000 but did not pay any dividends and, in Year 2, you made further profits of 30,000 after tax. You could declare a dividend at the end of Year 2 of up to 50,000. Illegal dividends (best avoided) We commented above that a dividend would normally be considered illegal if it s declared by the directors when there is insufficient after tax profits to cover the dividend. Well, if a dividend is illegal, then there are consequences. Firstly, a director could be found personally liable for any illegal dividend paid if the company goes into liquidation. But, what s more likely, is that the illegal dividend becomes repayable by those who ought to have known that the dividend is illegal. That usually includes the contractor and his family shareholders. The taxman also looks at illegal dividends and says that if it s repayable, then it s a loan and that may mean they raise a tax assessment on the company for tax of 25% of the value of the loan (take a look at our ebrief resources on the website for Loans made to directors ) If a dividend is declared when there are insufficient profits, this is an illegal dividend. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 7 8

9 Shareholding determines who gets paid the dividend When a company is created the first shares that are allocated to shareholders are called subscriber shares, and it s normal for only one type of share to be considered. The directors can issue additional shares later if they consider it appropriate, or they can go one step further and convert existing shares into several different classes (types) of share or create entirely new types of share if they wish. Every company has its own share structure When a dividend is declared by the directors, they agree how much dividend is to be paid on each share, and then the shareholders receive an amount according to the number of shares they hold. Classes of share We mentioned above that shares can be created as different classes (basically different types) of share. A class of share can be created by simply giving each class a different name and setting out the rights that each class has. Every share within a class of shares ranks equally, and so dividend and voting entitlements of shareholders are determined by the number of that class of shares held. We will return to share classes later and explore how you can use classes to direct income to the right person at the right time, without having to modify shareholdings. Declaring dividends on classes of shares means you can direct specific dividend amounts to each individual shareholder and manage the amount of higher rate tax each pays. Another real benefit of trading through a limited company is that if your circumstances support having multiple shareholders and additional employees other than just you then with good advice you can make best use of the allowances and lower rates of taxation available every year. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 8 9

10 Dividends and Tax planning If a dividend is payable to the holder of a class of shares, then we need to consider what we can do if one shareholder is a higher rate taxpayer while the other is not. This is a very typical scenario for contractors, especially where husband and wife, or civil partners, or coworkers both hold shares in the company. If you want to declare a dividend, but vary the amount of that dividend differently to the ratio of shares actually held, there are three ways to achieve this in theory: 1. Transfer shares between the individuals. But this can be unrealistic where each dividend is to be varied between the recipients in constantly changing proportions, and there are capital gains issues to consider because of course a share transfer is a disposal and acquisition of shares each time it occurs; 2. Dividends could be waived. This means one shareholder waives their entitlement to a dividend leaving the dividend to be received by the remaining shareholder(s). This is surprisingly very complex and can open up issues concerning settlements (see below); 3. Use different classes of shares. Each shareholder holds a separate class of share. This means that a dividend can be declared on one or more classes, and in whatever proportion suits the circumstances. The easiest solution is to create separate classes of share and have each shareholder hold the whole of each class. This planning opportunity has enjoyed a degree of popularity but you must seek guidance on the Settlements provisions legislation. Utilise all personal allowances and basic rates of tax available every year. Intouch clients: New client enquiries: T: E: E: enquiries@intouchaccounting.com W: W: intouchaccounting.com 10 9

11 Now I know what dividends are and how to get what to whom, when should they be declared? Using the rules to create a timing benefit can be much easier than you might think. Declaring and paying dividends is the decision of the directors which is then approved by the shareholders. Provided the profits are available then it should be done at the time to suit the shareholders. Moving the date by even a week around April can have amazing results. When are dividends treated as received? Dividends are deemed received when they become payable to the shareholders. (1) Interim dividends are payable on a date determined by the directors, however, under company law, the entitlement can be altered by the directors at any time, until the dividend is physically paid. So the correct treatment, accepted by HM Revenue & Customs (HMRC), is to deem interim dividends as received only when they are actually paid (2) A final dividend is payable on a fixed date proposed by the directors, but then subsequently requires formal confirmation by the shareholders which cannot be rescinded, and so (after shareholder confirmation) the approved due date is the deemed date of payment, irrespective of when they are actually paid. This form of planning is only appropriate in the right circumstances and does not suit all Personal Service Companies Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 10 11

12 On the whole, contractors generally declare interim dividends and these are treated as received on the date the directors decide to declare and pay them (most often this is the same date), confirmed by a process called the dividend declaration. This consists of a Board Minute to document that the directors have considered that profits are available for distribution, while also considering the future financial needs of the company. Not all dividends are paid in cash straight away. Sometimes declared dividends are shown as a loan due to the shareholder (often a director) when they want to take the cash at some future date, or used to effectively repay amounts already taken from the company. Once approved and the payment date set by the directors, the interim dividend is deemed to be received on the date payment is made. This date is very important to the shareholders, as it determines which tax year the income is deemed to fall into. An interim dividend declared on 1 April 2013, paid on 4 April 2013, but not banked by the shareholder until 10 April 2013 is treated as income for the shareholder during the tax year 2012/2013 even though banked by the taxpayer after 5 April, the income tax year-end. It is therefore important to consider the paid date when declaring dividends close to the year-end. Deferring tax payment dates with dividends Let s assume you normally don t pay higher rate taxes but one year you need to take more out than normal, such that a higher rate liability would be incurred on the exceptional amount being taken. Our recommended approach is to declare a dividend as immediately payable and pay it at the same time to avoid confusion. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 11 12

13 If you are careful you can use director s loans as a means to take the money when you need it and then declare a dividend to be payable by offset against the loan taken. So long as this dividend is declared and paid within 9 months after the end of the accounting period you won t have to pay the tax on an overdrawn loan account (there is always the issue of the interest free benefit in kind to consider). But you can use the time lag to make the dividend fall into a later tax year and defer the higher rate liability. The same technique can be used if ever you want to defer taxable income from one tax year to another; but be careful it s very easy to stockpile higher rate tax liabilities if you do not monitor this closely. Personal taxation liabilities arising from dividends When an individual receives a dividend they are receiving income that must be taken into account when working out if they have more personal tax to pay in that tax year. Because a dividend is paid from profits that have already been taxed (corporation tax), they are treated as received by an individual after a notional tax credit of 10% has been charged. This means that the dividend you receive is treated for income tax purposes as if it had suffered a deduction of 10% tax, even though no tax has been paid over. But don t worry dividends are not taxed at the normal basic rate of 20%. They are taxed at a basic rate of 10%. Are you subject to higher rate tax? To work out if you are subject to higher rate tax, you need to look at all of your income before tax was deducted, add everything up and, after deducting any available tax free amounts or other personal allowances, compare the remaining income figure with the tax bands for the relevant tax year. The important thing to remember is that dividends are always net of a 10% tax credit, so you would need to increase the dividend received to get the right starting point. To convert a dividend received net into gross income, simply multiply the dividend by 10/9. For example a dividend of 9,000 has a notional tax credit attached to it of 1,000, making it into gross income for tax purposes of 10,000 (9,000 x 10/9 = 10,000). This means that if the person receiving the dividend is only subject to basic rate income tax, then they won t have to pay any more tax on the dividend received. However, if you are subject to higher rates of income tax, then you will have to pay additional tax on any dividends. But take advice and choose that date wisely! Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 13 12

14 How is higher rate or additional rate tax calculated? For 2013/2014 the rates of tax payable on dividends are: Basic rate 10% Higher rate 32.5% Additional rate 37.5% Example at higher rate Assuming a net dividend of 8,000 falls into the higher rate tax band, then the additional tax payable would be 2,000. Below we show how that is worked out. Step 1 - Establish the gross income 8,000 x 10/9 = Gross dividend of 8, Step 2 - Establish the tax credit Tax credit at 10% of the gross dividend = Check: Gross dividend of 8, less the tax credit of = the net dividend received of 8,000. Step 3 - Calculate the higher rate liability Multiply the gross income by 8, x 32.5% = 2, Deduct the 10% tax credit of leaving 2,000 payable. So this looks like you ve saved tax because, rather than paying 40%, you ve actually incurred only the tax credit and paid a higher rate liability of 2,000 resulting in only 2, income tax. But, don t forget that the 8,000 available as a dividend is the remaining surplus (profit) and has already been subject to corporation tax. It s a bit techie to be honest, but if you give your accountant the information they do it for you Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 13 14

15 This table might help you understand the way this all works for the three rates of tax: Basic Rate Higher Rate Additional Rate From 6th April 2013 Company Profit 10, , , Corporation tax payable 2, , , Dividend 8, , , Notional tax credit Gross dividend 8, , , Applicable rate 10% 32.5% 37.5% Income tax , , Deduct tax credit Income tax payable , , Corporation tax payable 2, , , Income tax payable , , Total tax payable 20% 40% 44.44% Summary of dividend characteristics: 1. Dividends are a payment to shareholders of part of the accumulated profits after corporation tax of the company, and that they are payable to the holders of the class of share to which the dividend is declared. 2. Each shareholder is entitled to receive a dividend according to the number of shares they hold of the class to which the dividend is declared 3. Interim dividends are personally taxed according to when they are paid or for final dividends when they receive shareholder approval, not when the profits are made 4. Dividends are treated as being received after basic rate tax, and only higher and additional rates of tax are payable, according to the shareholders own personal circumstances. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 14 15

16 Conclusions Combine limited company dividends and salary in the most effective proportion and declare dividends at the best time for the shareholders. As frustrating as it may seem there is no single answer that will suit all contractors. Ignoring any moral objection to reducing your tax bill, your personal circumstances and attitude towards risk will determine the most efficient advice for you. This tax guide suggests the opportunities available but cannot consider all the variations in personal circumstances. These would include, but are not limited to: Your age, likely term of contracting career The expected and projected income levels now and in the future Views on pensions planning and saving Family status, including any partner s income Other income from outside of the contracting company IR35 risk status assessed for each contract Cash requirements to fund current lifestyle Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 15 16

17 Rules of Thumb Ensure as far as possible you identify your IR35 risk, if deemed within IR35 then forget the benefits of dividends It is common for contractors to pay themselves a modest salary and make up the rest of their required monthly income from taking short term loans from the business. At the end of an accounting period (month, quarter or year) or perhaps the end of the tax year, the extent of the loan taken from the company is assessed and its repayment will be made by the declaration of a dividend. The dividend declared is not actually paid in cash but used to offset the cash already taken from the business in advance. If the recipient of the dividend is close to higher rate tax thresholds then the timing of the dividend s declaration becomes sensitive especially around the end of the tax year (5th April). If the primary director s spouse or partner has no other income then perhaps they will have salary or dividends sufficient to utilise all personal allowances and basic rates of taxation. But there are pitfalls for the unwary so always make sure you seek professional advice. At Intouch we always consider your specific circumstances and can guide you on all your options, help you consider the wider implications and help you avoid running into issues with HMRC. Intouch clients: New client enquiries: T: E: enquiries@intouchaccounting.com W: intouchaccounting.com 16 17

18 ebrief for freelancers and contractors At Intouch Accounting, we work with contractors every day, helping them to understand their options, make the right decisions for their businesses and save money. So speak to us about how we can help you reduce the administration burden. Client Enquiries: New Enquiries: Skype: Intouchaccounting Online: intouchaccounting.com Intouch Accounting Ltd, Everdene House, Deansleigh Road, Bournemouth, BH7 7DU Registered in England & Wales - Company No