Your accounts for last year show a profit and you’re meeting with your fellow directors to decide whether it should be paid out as dividends. As tax will play a major part in your decision what are the most efficient options?
In most companies the directors can decide when to pay interim, but not final, dividends, i.e. those which are based on the trading results for the year. They must first be approved by the shareholders. Even if the directors and shareholders are largely the same people, there may be conflict if one of them wants dividends while another would prefer to defer paying them for tax reasons.
The most tax-efficient method of extracting profit is either to:
o pay it out as dividends. Income tax is only payable where director shareholders are liable to higher rates; or
o leave it to build up until you sell or wind up your company, in which case a special low rate of capital gains tax (CGT) applies.
Rates of tax – dividends
For 2014/15 income tax on dividends is zero where your total income is no more £41,450; if your total income is between £41,450 and £150,000 you’ll lose 25% of any dividend in tax and to the extent your total income exceeds £150,000, the tax on dividends is 30.55% of the excess.
Rates of tax – reserved profit
If you leave profit in your company with the aim of getting it out by selling or winding it up, CGT entrepreneurs’ relief will apply. This usually results in a 10% tax rate. Plus, you can use your annual CGT-exempt amount (currently £11,000) to reduce the tax bill further.
The perfect plan
It theory, the strategy is simple. Draw profit out as dividends up to the limit at which no income tax is payable, and leave the rest until the company is sold or wound up. However, putting this theory into practice requires planning.
Tip 1. Where your other income, i.e. everything but the dividends, is uncertain, don’t draw any dividends until March. At that time make your best estimate of income and take dividends accordingly so that your income stays within the zero rate tax band; that’s £41,450 for 2014/15.
Tip 2. Draw interim dividends during the year. In March if you think your income is above the zero rate tax band pay a pension contribution. This raises the limit at which income tax starts to be payable on dividends.
If the directors can’t agree, knowing the perfect tax plan won’t help you put it into action. Plus, if you want to keep profit in the company, waiving dividends isn’t a viable option as it will mean you’ll lose some of the income forever.
Tip. An alternative, relatively tax-efficient, solution is for your company to keep the profit in the company and lend money to the directors who need dividends. The loan can be added to each year and paid off when the company is sold or wound up. There are tax charges involved, but these are fairly modest .
For 2014/15 the most tax-efficient option, i.e. zero tax, is to pay dividends so that your total income reaches £41,450. Next most efficient is to keep the profit in the company and get it out when you sell or wind it up; 10% capital gains tax applies. An alternative solution is for the company to lend money to the directors.