Family companies should review profit extraction policy and consider whether they can and should pay further dividends before the end of the tax year.
Dividends can only be paid out of retained profits and thus, unlike payments of bonuses or salary, the amount that can be extracted from the company
as dividends is capped at the level of the company’s retained profits.
Retained profits are broadly profits on which corporation tax has been paid and thus they have already suffered tax in the hands of the company. For the
2019 financial year (i.e. running from 1 April 2019 to 31 March 2020), the corporation tax rate is 19%.
Once retained profits have been paid out as a dividend, they represent taxable income in the hands of the recipient. Consequently, the profits are taxed
again. The combined effect of corporation tax already paid on the profits, plus the dividend tax on the dividend, may be less than the income tax and
National Insurance contributions (NICs) that would be payable on profits paid out as salary, despite the fact that salary payments and employers’ NICs
are deductible in computing the family company’s taxable profits. Unlike salary and bonus payments, there are no NICs to pay on dividends.
In the hands of the shareholder, dividends are treated as the top slice of income and taxed at the appropriate dividend rate of tax. The dividend tax rates
are lower than the income tax rates, allowing for the fact that corporation tax has already been paid. Dividends are taxed at 7.5% to the extent that
they fall within the basic rate band, at 32.5% to the extent that they fall within the higher rate band, and at 38.1% to the extent that they fall
in the additional rate band.
All taxpayers, irrespective of the rate at which they pay tax are entitled to a dividend allowance (£2,000 for 2019/20). The allowance is really a nil
rate band rather than a true allowance in that dividends which are covered by the allowance form part of band earnings. Dividends sheltered by the
dividend allowance are taxed at a rate of 0% rather than at the relevant dividend rate. The dividend allowance is a useful tool.
Dividends come with company law rules, which must be adhered to. As well as restricting the amount of dividends that can be paid out to the level of the
company’s retained profits, to comply with company law requirements dividends must be paid in proportion to shareholdings. Different dividends can
be declared for different classes of share, providing the flexibility to tailor dividend payments to the circumstances of the recipient to ensure that
dividends can be paid out in a tax-efficient manner.
Companies are advised to undertake a review so that they can decide whether it is desirable to extract profits from the company before the end of the tax
year. If there are profits to be extracted, the company must decide how the profits should be extracted and who they should be paid to.
In order to answer these questions, it is not only necessary to establish what profits are likely to be available for extraction, but also what other income
the family members have, whether their personal allowance and/or dividend allowance remains available and whether they have used up all of their basic
or higher rate bands.
As a starting point, it is generally tax-efficient to pay a small salary and to extract further profits as dividends. Assuming the recipient’s personal
allowance is available, the optimal salary is equal to the primary threshold for Class 1 NICs purposes (£8,632 for 2019/20) where the employment allowance
is not available. If the employment allowance is available, the optimal salary is equal to the personal allowance (assuming that this is not used elsewhere),
set at £12,500 for 2019/20. Above this level, it is generally more efficient to extract profits as dividends. Before paying out dividends, consider
whether the optimal salary has been paid.
However, it should not be forgotten that there are other options for extracting profits, such as rent where the business is operated from a room in the
family home, benefits-in-kind, pension payments etc.
Undertake a review prior to the year end to determine whether it is advisable to pay dividends before the end of the tax year.