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When a firm is run by a family as a family company, it is vital to remove revenues from the company so that they can be used for personal reasons outside of the company. For example, these profits could be used to pay for day-to-day expenses. When developing a plan, it is best to practise extracting profits in a manner that is as tax-efficient as feasible. This is because the act of extracting profits may result in additional tax and National Insurance payments. The manner in which this will appear will, to some extent, be contingent on the specifics of each person’s situation. Having said that, a common and tax-efficient method for profit extraction is to take a modest salary and then withdraw additional income in the form of dividends. This strategy is becoming increasingly popular.
In the tax year 2022/23, the ideal salary to shelter an employer’s National Insurance is equal to the primary threshold of £11,908 in cases where the employment allowance is not available, and it is equal to the personal allowance of £12,570 in cases where the employment allowance is available. This is based on the assumption that the personal allowance will not be used for any other purpose.
Allowance for dividends
The allowance for dividends is not an allowance in the traditional sense. Instead, it is a band with no rate at all. When dividends are calculated using this band, they are subject to taxation at a rate of zero, which means that the shareholder does not owe any taxes on the money received as a result of receiving the dividends. Everyone who files taxes can make use of the dividend allowance, regardless of the marginal tax rate they are subject to. The dividend allowance will be capped at £2,000 for the fiscal year 2022/23. Dividends are subject to income tax at the highest marginal rate, and the dividend allowance eats away a portion of the tax band in which the dividends themselves fall.
Distribution of dividends
In the context of a family business, the availability of the dividend allowance is a factor that can be used to influence dividend policy. However, while paying dividends in order to make use of available dividend allowances, it is important to keep in mind that dividends can only be paid out of retained earnings and must be paid in accordance with shareholdings. This is the only way dividends can be paid. The use of an alphabet share structure, in which each shareholder has their own Class of shares (for example, A ordinary shares, B ordinary shares, C ordinary shares, etc.) and which provides the flexibility to tailor dividends to individual circumstances, is one method that can be utilised to get around this problem.
After-tax profits are used to pay dividends, which means that the firm has already paid its tax obligation. In the case of a family company, it is prudent to make family members shareholders, even if they have other sources of income and do not work for the company, because this will prevent dividend allowances from being lost and will maximise the opportunity to extract profits without triggering additional tax liabilities. In addition, this will maximise the opportunity to extract profits without triggering additional tax liabilities. The following case study provides illustrative evidence of the benefits.
Case study
Dave is the head of the family business, which goes by the name DJ Ltd. His two grown daughters, in addition to his wife, are all shareholders in the company. Dave has 100 ordinary shares of class A, his wife has 100 ordinary shares of class B, and each of his daughters, Delia and Diane, has 100 ordinary shares of class C and 100 ordinary shares of class B.
Dave is interested in taking his share of the company’s net profit, which came to £20,000 after taxes. Both Dave and his wife, Debbie, have received a salary from the company in the amount of £12,570 each. Both Dave and Debbie are subject to the more onerous tax rate since they have income from the property.
Dave will be entitled to a dividend payment of £20,000 in the event that A class shares are entitled to a dividend of £200 per share. After taking into account the dividend allowance of £2,000, the remaining sum of £18,000 is subject to taxation at a rate of 33.75 per cent, which results in a tax liability of £6,075.
If, on the other hand, the company decides to declare a dividend of £1,400 per share for shareholders in the A class and a dividend of £20 per share for shareholders in the B, C, and D classes, Dave will receive a dividend of £14,000, while his wife and daughters will each receive a dividend of $2,000 in this scenario.
In this hypothetical situation, Dave will have to pay taxes on his income totalling £4,050 (33.75 per cent of £14,000 minus £2,000). However, his wife and daughters will not be subject to income tax on their dividends since they have dividend allowances that exempt them from paying tax.
The total tax burden has been cut by £2,025 thanks to the implementation of an alphabet share structure and the utilisation of dividend allowances provided to members of the same family.
If his daughters have not utilised all of the basic rate bands available to them, adjusting the dividend mix to take advantage of this could result in additional cost savings.