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Dividend Tax changes, Is incorporation still worthwhile?

The new dividend tax has arrived. As from 6 April individuals can earn up to £5,000 in dividends without any income tax charge, but any amounts received above this level will be taxed at 7.5%, 32.5% and 38.1% depending on the tax band.


This has left many practitioners wondering how these new rules will affect their small company clients, and whether it still makes sense to incorporate. This article looks at both questions for businesses with various levels of profit.

So how will the dividend tax affect clients already running one-man band companies?

The table below shows the total tax bill (i.e. both corporation and income tax combined) for one-person companies with profits of £50,000, £100,000 and £150,000. All our calculations assume that business owners draw salaries from this profit equal to the NIC primary threshold (£8,060 for both years), and that all post-tax profits are paid as dividends. And all the resulting tax figures are rounded to the nearest £100.

Total tax bills for a one-person company

Total tax bill

                                                                                       2015/16                                   2016/17                              Increase
Profit:
£50,000                                                                           £8,800                                     £10,300                                £1,500
£100,000                                                                       £28,800                                    £33,000                                £4,200
£150,000                                                                       £53,000                                    £60,500                                £7,500

So small companies face substantial increases in their total tax bills as a result of the dividend tax. The percentage increase in the total tax bill ranges from 14% to 17%.

What about a ‘husband and wife’ family business?

If we compare tax bills for a two-person company, where profits are divided equally, the total tax bill will be higher in 2016/17 in all the scenarios above.

The percentage increases are similar to single-person companies, ranging from 12% to 17%.

Total tax bills for a two-person company

Total tax bill

                                                                                   2015/16                                   2016/17                                    Increase
Profit:
£50,000                                                                    £6,800                                       £7,600                                          £800
£100,000                                                                 £17,600                                     £20,600                                        £3,000
£150,000                                                                 £37,600                                     £42,900                                        £5,300

So, given these tax rises, does it still make sense to incorporate?

The answer is yes, but only if profits are below a certain level. The table below shows the tax savings achieved by switching from a sole trader to a single-person company for various profit levels.

Tax savings from working via a single-person company v self-employment

Tax saving from incorporation
                                                                                 2015/16                                      2016/17
Profit:
£50,000                                                                   £4,000                                          £2,300
£75,000                                                                   £4,500                                          £1,700
£100,000                                                                £5,000                                          £700*
£125,000                                                                £7,400                                          £3,800*
£150,000                                                                £6,000                                          (£1,400)

[* The tax saving from incorporation is higher when profits are £125,000 versus £100,000 because the personal allowance of a sole trader is scaled back sooner than someone drawing (post-tax) dividends from a company. However the tax saving from incorporation starts falling again when this effect ends.]

Although the tax savings are substantially lower than in 2015/16, incorporation still makes sense for businesses with profits below £150,000. But a business with profits at (or higher than) this level will be better off working as a sole trader.

Is the same true for a husband and wife business? If we compare a partnership to a two-person company, where profits are split equally in both cases, incorporation still makes sense provided profits are below £300,000.

Tax savings from working via a two-person company v partnership

Tax saving from incorporation
                                                                                  2015/16                                      2016/17
Profit:
£50,000                                                                     £2,300                                          £1,300
£100,000                                                                   £8,000                                          £4,600
£150,000                                                                   £9,000                                          £3,300
£200,000                                                                 £10,000                                          £1,300
£250,000                                                                 £14,900                                          £7,600
£300,000                                                                 £12,000                                         (£2,900)

So what can we conclude from the analysis above?

The first point is tax bills are going to be higher for small companies across the board, and business owners need to start setting more money aside. The rise will vary according to circumstances, but a good rule of thumb is tax bills in 2016/17 will be 15% higher than in the previous year.

The second point is it still makes sense to operate via a limited company provided profits are below a certain level - £150,000 for a single-person business and £300,000 for a two-person firm. Businesses earning (or expecting to earn) more than these amounts should look at alternatives, including LLPs if limited liability is an important issue.

But, all in all, it still makes sense for many small businesses to operate via companies, and tax-driven incorporation is likely to continue, albeit at a slower pace than in the past.