I went on the BBC’s Any Questions programme last week. The questions weren’t madly interesting (nothing, for example, on when and how lockdown should end). But there was one that was rather more interesting that it might have seemed.
An owner/director of a small company asked whether the panel thought (as he did) that special provision should be made for people such as him. A large number of owner directors pay themselves only a small part of their income as salary. Anything they need to take out beyond that they take as dividend payments.
Paying a little as salary is important. It means that you build state pension qualifying years and that you can make higher than minimum personal pension contributions – and it helps if you need to take out a mortgage. But, if you want to cut your tax bill, it also makes sense to pay the bulk of your income in the form of dividends: there is no employer’s or employee’s NICs (National Insurance contributions) on a dividend, and dividends attract lower levels of income tax than salary.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Dividends are (currently) a legitimate way of minimising your tax bill
The upshot is that, overall, most advisers will suggest that anyone wanting to minimise tax bills set their salary somewhere between the lower earnings limit (to get the state pension years) and the “primary threshold” (where you start paying NICs). Chuck in the tax free allowance of £2,000 on dividends and the smart director can make up to £14,500 a year without paying any income tax at all.
Here’s a nice example from the IFA website Unbiased.co.uk:
Jane takes a salary of £8,600 (keeping below the threshold for paying NICs or income tax on it) and takes a further £30,000 in the form of a dividend. Her total income is now £38,600. She has a tax-free personal allowance of £12,500 in 2019/20, leaving £26,100. Her dividend allowance means the first £2,000 of dividends are tax-free, leaving £24,100 that is taxable. This £24,100 is taxed at the dividend basic rate of income tax, which is just 7.5%. So Jane’s income tax bill for the year will be £1,807. If Jane had taken the whole £38,600 as salary, then her income tax bill would have been 20% of £26,100 – which is £5,220. She would also have to pay £3,596 in NICs. By taking her income in a combination of a low salary plus dividends, Jane has saved over £7,000 in that year.
The good news is obvious. If you are a director/owner and you are keen on tax efficiency you can save an awful lot of money by structuring things correctly (although note it is less simple than it seems as dividends are paid after the companies pay corporation tax at 19%). You can also see how your company is doing every year before deciding at the end of the year how much to pay yourself (although this could be done by paying yourself a bonus inside the PAYE system as well).
The trouble with the furlough scheme
On to the bad. It’s easy for the government to finance staff furloughing – records show who has earned what and when. It’s also relatively easy to deal with the self employed: their tax returns show how much they have previously earned from their work. But when it comes to owner-directors, how is the government to know that you consider the dividend to be earned rather than unearned income?
If it is using tax returns to attempt to replace salaries during the coronavirus crisis, how is it to tell the difference between you paying yourself in dividends from your company and another person getting £20,000 in dividends from, say, an income fund (something that definitely can’t be classified as a sort of salary). We don’t declare where our dividends come from on our tax returns, we just declare the amount.
According to lobby group IPSE (the Association of Independent Professionals and the Self Employed), the result of this difficulty (which the chancellor has not yet managed to resolve) is that some 700,000 owner-directors have fallen through the net (the IFS suggests up to two million) – and, beyond the small payments they might be able to get from furloughing themselves from the salaried part of their work (which most don’t want to do or they can’t legally carry out basic work such as paying suppliers), are getting nothing from the state.
The system needs a proper rethink
So what’s to be done? On Any Questions we all agreed that the answer is “something”. We need these businesses and those who work within them to be offered a bridge to the other side – just like all other businesses and workers.
The solution, then, is probably something like that suggested by IPSE: we let the directors self report their dividend income and also self certify that the dividend income is effectively paid as a salary top up. Later any fraudulently claimed is clawed back, with penalties.
But, after that, we might need to have a full rethink of the inequities in the system. There is something awkward about those who take advice on how to lower their tax bills complaining about being less generously treated by the handout system than those who have had no similar opportunity to avoid tax. And something just as awkward about watching them trying to reclassify what they had wanted to be taxed as unearned income as earned income.
It might just be that, post crisis, we think about taxing earned and unearned income in a more equal way. A simpler system might help us tie ourselves up in fewer of these nasty knots.
Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).
After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times
Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.
Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.
Who is the richest person in the world?
The top five richest people in the world have a combined net worth of $825 billion. Who takes the crown for the richest person in the world?
By Vaishali Varu Published
Top 10 stocks with highest growth over past decade - from Nvidia, Microsoft to Netflix, which companies made you the most money?
We reveal the 10 global companies with the biggest returns since 2013. One firm has posted an astonishing 9,870% return, meaning a £1,000 investment would now be worth almost £82,000.
By Ruth Emery Published
UK wages grow at a record pace
The latest UK wages data will add pressure on the BoE to push interest rates even higher.
By Nicole García Mérida Published
Trapped in a time of zombie government
It’s not just companies that are eking out an existence, says Max King. The state is in the twilight zone too.
By Max King Published
America is in deep denial over debt
The downgrade in America’s credit rating was much criticised by the US government, says Alex Rankine. But was it a long time coming?
By Alex Rankine Published
UK economy avoids stagnation with surprise growth
Gross domestic product increased by 0.2% in the second quarter and by 0.5% in June
By Pedro Gonçalves Published
Bank of England raises interest rates to 5.25%
The Bank has hiked rates from 5% to 5.25%, marking the 14th increase in a row. We explain what it means for savers and homeowners - and whether more rate rises are on the horizon
By Ruth Emery Published
UK wage growth hits a record high
Stubborn inflation fuels wage growth, hitting a 20-year record high. But unemployment jumps
By Vaishali Varu Published
UK inflation remains at 8.7% ‒ what it means for your money
Inflation was unmoved at 8.7% in the 12 months to May. What does this ‘sticky’ rate of inflation mean for your money?
By John Fitzsimons Published
VICE bankruptcy: how did it happen?
Was the VICE bankruptcy inevitable? We look into how the once multibillion-dollar came crashing down.
By Jane Lewis Published