Dividends, directors and the holes in the government’s coronavirus furlough scheme

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.

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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.