Many small companies have paid corporation tax at the 19% rate of corporation tax, and have then extracted profits using a combination of a small salary to cover the personal allowance, and the remainder of the profits extracted via dividends. This is still likely to be a popular strategy to extract profits as its ensures that full use is made of salary to utilise the personal allowance, with dividends, (generally a lower tax option) making up most of the extraction.
A lot of companies have combined this with the benefits of a non earning spouse and have paid 2 small salaries and extracted dividends equally to the married couple. The Arctic systems decisions, eventually gave them some support but the Government is to introduce new income splitting rules from April 2008 to counteract this.
How will the new rules work?
We’ll be writing a separate article on the details of the provisions however in short where there is a business with low capital assets and where most of the work is undertaken by one of the spouses they’ll be looking to tax dividends solely on that spouse. Therefore the fact that the dividends are paid out equally is effectively ignored and they are deemed to arise on the main ‘breadwinner’ for income tax purposes. This will then mean that rather than having two basic rate taxbands to utilise, instead there will only be the one.
For many small businesses when you add in the fact that there are also changes to the corporation tax rate as well (increasing to 21% this year and then 22% next year) they’ll be seeing their tax payments increase pretty heavily this year. The marginal tax rate increases pretty substantially on profits of £80,000 – £100,000. After that the gap narrows. The larger the profits after that the smaller the gap as the tax saving from the additional basic rate band represents a smaller share of the profits. In terms of reducing income tax you’ll be looking at retaining cash in the company, making tax effective investments (eg EIS/VCT) and extracting as non residents. All these could be effective. You could also opt for a completely different tack and look at extracting salary rather than dividends. Providing you combined this with significant pension contributions this could be highly tax efficient.
A complete version of this article with illustrative tables is available at http://www.wealthprotectionreport.co.uk.
Lee J Hadnum is a rarity among tax advisers having both legal & chartered accountancy qualifications. After qualifying as a prize winner in the Institute of Chartered Accountants entrance exams, he went on to become a Chartered Tax Adviser.
He previously ran his own his own tax consulting firm, and has written a number of tax books as well as editing the popular tax planning