For many years owner managed businesses have had a fairly stable system of taxation at shareholder level.  Most business owners pay themselves a reasonable level of salary but they also have the option of extracting profits from the company by way of dividends which reflects the fact that they do not have the same level of financial stability as an employee.

Due to the way that dividends are taxed on individuals this has resulted in a tax efficient way of profit extraction for the majority of owner managed businesses.

Under the rules that continue until 5 April 2016, the company paid corporation tax at 20% on the profits of the company, but there was no national insurance (either employer or employee) on dividends paid out of those profits.  Furthermore, the individual receiving the dividend was deemed to have a tax credit which covered any basic rate liability.  A higher rate taxpayer would pay an effective tax rate of 25% and an additional rate taxpayer would pay tax at 30.6% on the dividends paid.

However, as part of the new measures introduced in the Summer Budget these rules are set to change from 6 April 2016.

Under the new rules every person will have a £5,000 dividend allowance which will not be taxed.  Dividends paid in excess of £5,000 will be taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.

This could result in a significant increase in the tax liability for the shareholder of an owner managed business.  Particularly badly effected will be those companies which have a number of family members as shareholders.

It is clear from the changes announced that most, if not all, owner managed business shareholders will be worse off under the proposed rules.  It is therefore imperative that potential planning ideas are considered as early as possible during 2016.

There are some of the ideas that might be explored:

  • Bringing forward dividend payments into the 2015/16 tax year is one such idea. However, this needs to be considered in the round as although the tax liability might be lower overall, this route also brings forward the payment date for the tax bill.
    Anyone pursuing this option also needs to ensure that the correct paperwork is put into place to evidence that the dividends have been paid during the 2015/16 tax year.
  • Ensuring that the £5,000 dividend allowance is properly utilised by all shareholders. This is particularly useful where there are a number of family members who own shares.
  • Consider making pension contributions to reduce the tax burden. This can be more attractive to shareholders now given the new flexible pension regime.
  • Consider whether utilising a director’s loan account is appropriate as an alternative method of profit extraction. This route will result in a 25% corporation tax charge in the company plus a benefit in kind on the director based on the official rate of interest.  This option is not appropriate for everyone and should be considered on individual merits.

The overarching message is that each taxpayer needs to review their personal circumstances and take appropriate advice.

From April 2016, the company will no longer be as tax efficient for owner-managed businesses as previously.  However, there are many other reasons that individuals choose to incorporate their businesses, including benefiting from the corporate veil, credibility of running the business through a company or the ability to incentivise staff more efficiently through a corporate structure.

It is therefore likely that, despite the changes, the corporate structure will continue as a popular choice for business.  Although the impact of the changes will remain to be seen.