2016/17. Contractor companies
Written by Ray Coman
Yesterday’s Budget announcement Budget on the taxation of dividends has significant tax implications for company owners.
The current system for contractors
Currently, contractors providing their services via a company are liable to corporation tax on profits. To the extent that dividends increase total income into higher rates of tax there is additional tax to pay.
In a typical scenario where a person has little or no income from outside the company, it is tax efficient to pay a salary up to the national insurance threshold. This is £8,060 for 2015/16. Provided the director has no other income, the salary results in no income tax and is deducted from corporation tax profits. The taxpayer is effectively in the same position as an employee or sole trader who can also have income up to the personal allowance (of £10,600 for 2014/15) tax free.
The remainder of profits are treated as dividends. The basic rate tax threshold is £31,785 for 2015/16. Given the first £8,060 is paid in salary, the most net dividend that can be paid to an individual without making that person a higher rate taxpayer is £30,892 in 2015/16.
In a typical scenario a company owner will receive a salary, so that the first £8,000 of profits are effectively tax free, provided there is no other income, the next £30,000 or so of profits taken out of the company also result in no income tax. To the extent that dividends increase total income into higher rate of tax an effective rate of 25% is payable. Since dividends are paid out of after tax profits, for a higher rate taxpayer, the combined effect of corporation tax (20%) and income tax (80% of 25%) is 40%.
The new regime
From April 2016, the tax payable by a contractor will likely increase. Profits will be calculated after deduction of director’s salary and corporation tax will be applied to profits.
Any contractor, with personal allowance fully used and, with a dividend of more than £5,000 will be paying more tax than before.
In total, transfers from the company bank account to the director’s personal bank account of more than £13,060 (in salary and dividend) will result in more tax. In 2016/17 a person can receive total income of £43,000 before being a higher rate taxpayer. Therefore, a contractor will be taxed at 7.5% on income between £13,060 and £43,000.
In 2016/17, a shareholder with dividends of £34,940 (and salary of £8,060) will be taxed at 7.5% on £29,940 of dividends. An increase in tax of approximately £2,246, compared with the same situation in 2015/16.
The national insurance rates are scheduled to alter in line with the income tax rates. For the purposes of example, I will base 2016/17 rates on the 2015/16 levels. An employee with earnings of £43,000 a year would pay approximately £4,200 a year in national insurance. A self-employed person with £43,000 profit, would pay approximately £3,150 a year in national insurance.
There will still be a tax benefit for a basic rate taxpayer from using a company, although significantly reduced from April 2016.
For self-employed individuals, the increase in accounting costs only justify the saving in national insurance when income reaches about £15,000 to £20,000. For a person self-employed, with profits between £15,000 and £43,000 there is still tax efficiency achieved by operating via a company.
For a higher rate taxpayer, the new dividend rate is 32.5% compared with 25% previously. If all company profits are taken as dividend, the combined income tax and corporation tax rate for a higher rate taxpayer is 20% plus (80% of 32.5%), or 46%. This is higher than the income tax and national insurance paid by higher rate taxpayers who are either employed, sole traders or partners, where the marginal rate is effectively 42%, i.e. 40% income tax and 2% national insurance.
In the example above an employee on £43,000 would save £1,954 (i.e. £4,200 less £2,246) by providing services via a company. A sole trader would save £904 providing services through a company. The extra 4% payable by higher rate taxpayers will gradually erode this tax advantage. A sole trader would be no better off using a company when total income reaches £65,600, and thereafter worse off. This calculation compares saving in national insurance with increase in income tax only.
The comparison with an employee is less relevant since an individual who would be employed ‘but for’ the company should be taxed under the old ‘IR35’ rules. However, for illustration purposes only, an employee may need to earn as much as £91,850 a year to be no worse off than if operating via a company.
Notwithstanding, there are other tax benefits to the corporate structure. An employer saves considerable national insurance by using contactor. Employer’s national insurance is currently 13.8% on earnings over the primary threshold of approximately £8,000 a year. The flat rate scheme will remain available to sole traders and company owners with total turnover of less than £150,000. A considerable potential tax advantage over employees who cannot be VAT registered.
Moreover, there is some respite for contractors in the form of a drop in corporation tax, falling to 19% in 2017 and 18% in 2020. This saving in corporation tax from 2017/18 and thereafter will help to mitigate the tax increase explained above.
A suitable tax plan is to consider withdrawing dividends prior to 5 April 2016. The following article outlines other methods for withdrawing company profits. A further consideration may be to revert to employment which has a number of advantages compared with being self-employed.