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Dividend Tax changes take effect from April 2016. ContractorCalculator CEO Dave Chaplin explains the changed legislation and to what extent working mums will be affected.
New Dividend Tax changes take effect from April 2016 that will result in working mums’ limited company businesses paying in excess of £1,700 of extra tax each year.
The current system of grossing-up dividends is to be abolished. It will be replaced with a simple rate of tax on net dividends. The tax bands will be 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
The changes are primarily to restrict companies from engaging in ‘tax motivated incorporation’, but calculations suggest that small business owners and freelancers – particularly family owned and husband and wife teams – are set to be disproportionately impacted by the new rules.
If you are a working mum with a freelance businesses and you are concerned about how much tax you will have to pay from April 2016, you can use ContractorCalculator’s Dividend Tax Changes Impact Calculator and dividend lookup tables to calculate how much extra tax you will pay.
The tax is also set to be implemented as a means of levelling the playing field in terms of tax paid by individuals working as sole traders or partners in partnerships compared with those operating through limited companies.
Freelancing mums who are classed as sole traders or who operate in partnerships will not be affected by the new rules, but freelancers who work through limited companies will feel the sting at various levels of severity, depending on their dividend income and the tax band they fall into.
As it stands, basic rate taxpayers don’t pay any tax on dividends, whilst dividend income is also supplemented by a tax credit of 10%. Currently, and until 6 April 2016, company profits will first of all be subject to corporation tax, charged at a rate of 20%. The remaining amount is then grossed up by 10 ninths in order to account for the tax credit, resulting in the gross dividend.
This tax credit will be abolished next April and will be replaced with a Dividend Allowance of £5,000. This is not actually an allowance, but a zero rate band. This means that the first £5,000 of a freelancers’ income through dividends will be taxed at a 0% rate.
After this, the tax rate will be 7.5% for basic rate taxpayers. Meanwhile, the tax rates will increase from 25% to 32.5% for higher rate taxpayers and from 30.6% to 38.1% for additional rate taxpayers. Essentially, within each tax band the rate will increase by 7.5%. These rates will be applicable to all dividends.
The higher rate tax threshold is set to increase to £43,000 in the 2016/17 tax year. It is worth remembering that dividend income is still eligible for the personal allowance, which is set to increase to £11,000 in April 2016.
Current National Insurance Contribution (NICs) thresholds mean that the recommended optimal salary for director/shareholders of one-person limited companies is £8,060 a year. This leaves your freelance business with a dividend limit of £34,940 before reaching the higher rate threshold of £43,000.
From this amount you deduct £5,000 for the Dividend Allowance and the remaining £2,940 from the personal allowance. This leaves £27,000 which is subject to dividend tax at the basic rate of 7.5%, leaving your freelance business with a dividend tax liability of £2,025.
Any further dividend payments would be subject to the higher rate of dividend tax. For example, an additional £10,000 in dividend income would yield £3,250 in dividend tax, bringing the sum total to £5,275. In comparison, under the current rules, such an arrangement would yield £2,500.
Freelancing mums trading via a limited company still look set to benefit from lower tax rates than those working as sole traders, providing their annual gross income is below £140,000, from which point the effective tax rates are equal. However, the margin will be far smaller as of April 2016.
When comparing the average tax liabilities of limited companies and sole traders on yearly earnings up to £200,000, freelancers are currently 5.1% better off when extracting their profits from their limited company than they would be when operating as a sole trader. As of April 2016 this average margin will be reduced to 1.4%.
Although the tax benefits will reduce, it also worth remembering that trading via a limited company has many other advantages. These include ring-fencing personal assets from business assets and liabilities and being able to build a business and a brand that has a separate identity to the business owner.
*Dave Chaplin is CEO of ContractorCalculator.