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Tax laws are complicated, but it’s good to know the legal ways to lower your tax obligations. “Legal” is the wrong word here. There are legitimate ways of reducing your tax obligations. This is why we are here to explain a few of the basics and help you avoid some of the most common problems small businesses, directors and self-employed contractors encounter when they’re filing their tax returns. In particular, we want to help you avoid the tax-related pitfalls of paying yourself a dividend rather than drawing a salary in your role as an owner-director of a limited company. The truth is that many business owners can reduce their tax liability by making intelligent decisions about how they structure their finances and business operations and also thinking about how they will pay themselves. Don’t mistake this article for tax advice; it is general advice and not intended as legal advice or any substitute about your specific circumstances. But here are a few things to keep in mind next time you’re filling out your self-assessment tax return.
They say there are two kinds of people in this world: those who love dividends and those who hate paying them. It’s a common misconception that you can avoid paying tax on your salaried income by drawing an illegal dividend from your company instead. But you’d be wrong! HMRC has laid various traps in their tax return forms, and one of these traps targets small business owners that attempt to avoid tax by drawing an illegal dividend.
So, here’s what you need to know: The amount company directors are permitted to pay themselves as a dividend can only be taken from the profits that are left once all other expenses, including corporation tax, is paid; rents, utility bills, accountancy costs, etc.
So, are you aware of this dividend trap? It’s scary, but it can happen if you don’t watch out for it. As you know, companies need to show a demonstrable profit from the current year and previous financial years in order to pay dividends to shareholders. But here’s the catch: sometimes, businesses do this even when they have a loss, which means that they have to borrow money! But, of course, we never want to find our clients in that situation, so we’re just checking in with you now (before the year ends) to ensure that you are on track to stay profitable enough to pay out dividends and include them in your self-assessment tax return.
HMRC have strict rules in place. In most cases, tax officials will chalk off mistakes as honest mistakes – but they may still hand out penalties if they think you have been careless when filing your tax return or suspect you are trying to avoid paying tax.
Tax penalties are as follows:
- Leniency may be shown if you took reasonable care and made an honest mistake because you didn’t understand what was being asked of you. Penalties in these instances are not applicable.
- If HMRC deems you have been careless, you may have to pay up to 30% more of your total tax liability.
- If the tax suspects you have deliberately tried to evade tax, their penalty will be between 20-70%.
- If you are found to have underestimated your tax obligations and attempted to conceal the fact, the penalty will be between 30-100%.
Whenever HMRC accuse a business owner of paying an illegal dividend, they will argue that the dividends should be classed as salary. And wages are taxable and may even mean paying a higher tax rate, including national insurance—which means you have to pay more in taxes.
More money for the government? KILL IT WITH FIRE!
So how do you save money? First, you have to prove to the taxman that you are not deliberately underestimating your tax obligations or trying to conceal evidence. You are legally obliged to hold a board meeting with the shareholders and keep written records of how much each shareholder is entitled to in dividends. This is also the case even if you are the only director.
Dividends up to £2000 are tax-free. Anything above that is taxed at the following rates depending on the individual circumstances’:
Basic rate: 7.5%
Higher rate: 32.5%
Additional rate: 38.1%
HMRC’s crackdown on dividend payments isn’t just a tax issue. It can also be a business issue and one that you should be aware of to avoid getting caught up in any unnecessary complications.