Avoid the taxman netting your contractor dividend
They may have written best-practice books on scale, resources and growth, but FTSE firms are far from setting an example to contractor limited companies when it comes to dividends, writes Martin McKechnie, director of The Low Tax Group.
In fact, a reported study by the Share Centre shows that profits at FTSE 350 firms now cover a much smaller multiple of dividends than they did only two years ago, leading to warnings by the study authors that these company dividends cannot continue to outstrip profits indefinitely.
Whenever you, a limited company contractor, want to pay a dividend there is a ‘belt and braces’ approach you should follow, which is a six-part process. Listed below, this process not only factors in profitability – something the FTSE firms should be more aware of – but also can help keep the taxman off your doorstep.
It’s worth bearing in mind that, in the past, HM Revenue & Customs tended to investigate cash-based businesses. But with cash used less and less, HMRC are now focussing on ensuring that companies and directors are documenting all the transactions in their accounts properly, and in accordance with the Companies Act and the Finance Act.
So if you are considering paying a low salary, high dividend, which can save contractors a significant amount of money in terms of National Insurance, then you should stick to the following process, or risk being caught by HMRC and consequently paying tax, penalties and interest.
The ‘belt and braces’ approach to issuing a dividend as a contractor limited company
- Assess the profit of the limited company at the point at which you want to pay a dividend. Remember: Turnover – expenses = profit.
- Calculate the corporation tax due on that profit (currently 20% for profit below £300,000).
- Then calculate the profit after tax is deducted. It is this amount which is available for payment to the shareholders. Remember: a dividend is simply a distribution of after-tax profits to the shareholders.
- Once that is assessed, you may vote an appropriate dividend i.e. one that the company can sensibly afford without detriment to its ability to continue trading. This may also require a board meeting in certain circumstances.
- You need to document the dividend, by creating a dividend voucher. This is a legal document that all companies who issue dividends create and issue to shareholders. Most good contractor accountants normally do this for their clients.
- Once a dividend voucher has been created, then you can actually pay a dividend.
If you are going to pay a dividend every month, due to mortgages, bills etc. you must go through this six-part process each time. If you are invoicing the same amount each month and have recurring expenses, then this calculation is unlikely to vary much. Again, most good accountants serving contractors normally run these calculations for their clients.
It is worth bearing in mind, dividends are the distribution of profits after tax. Therefore if you don’t document and follow this process correctly, HMRC may take the figures you have drawn and not documented correctly and claim that they are either a salary or that they are forming a Directors’ Loan, both of which would have negative tax consequences.
If HMRC classes it as salary…
The amount paid could be classed as the net salary, therefore being the amount paid to the employee. That being the case, it will have to be grossed up for tax and NI purposes and paid over to HMRC by the company.
Remember: this NI comes in 2 forms; Employers' NI – charged at 13.8% of gross salary and Employees' NI – charged at 12% of gross salary.
Combined, this amounts to 25.8% in NI costs, which would otherwise be unnecessary. Remember: This 25.8% is not of the net dividend but after the dividend is grossed up for tax and NI, so it is significantly higher than it appears at first.
If HMRC classes it as a Directors’ Loan...
If HMRC claim that the actual payment constitutes an overdrawn Directors’ Loan Account (above £5,000 in 2013/14, raising to £10,000 on April 6th 2014), then the company has to pay 25% in additional corporation tax if that loan is not repaid (and evidenced).
Another cost if you have an overdrawn Directors Loan Account, is the class 1a NI charge payable by the company. This is charged at 13.8% of a notional interest rate and can never be recovered even when the loan is repaid.
Remember: You can’t accrue (back date) a dividend, so you can’t wait until after your company has had its financial year and go back and decide what you are going to call your dividends at a later date.
Further dividend considerations for contractors
There is always a difference between the accounting period of the trading company and the fiscal tax year of the country which defines every individual’s personal tax position and payment schedule, e.g. a limited company may have a June or October year-end but as an individual you have a year-end of April 5th only. So when paying dividends, it is important to consider how you are utilising your zero rate and basic rate tax allowances. If you are a particularly high earner (above £100,000) the timing is even more crucial.
Married or in a civil partnership?
If you have a partner who is not utilising all of their allowances (be it zero, basic or higher rate) then considering paying dividends to a spouse, who may also be made a shareholder - this can also have a dramatic impact on the amount of personal tax payable on those dividends. This needs to be structured correctly and you should seek to consult a specialist accountant who can assist in this area.
With HMRC showing no sign of slacking in its pursuit of limited companies, it is imperative that contractors understand the entire process when utilising the tax-effective strategy of low salary and high dividends - firstly to ensure you are doing all you can to keep more of what you earn and, secondly, to avoid any nasty surprises.