Tax Efficiency of Limited Company Dividends

Confusion over the tax benefits of drawing dividends from a limited company

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Hi all, I am curious about dividend payment structure in a limited company. I wonder if anyone can help.

Hypothetical scenario:

A limited company has a director who is the sole employee. They draw a salary £9,100pa at the NI secondary threshold so that there are no NI obligations.

The director can take a further £5,470 in dividends before incurring personal tax (£3,470 to use up to the personal allowance plus £2,000 dividend allowance).

The director now has an income of £14,570pa.

The company has paid 19% tax on the underlying profit that the dividends are paid from. It would need £6,753 of income to enable a dividend payment of £5,470.

So, the company needs an income of £15,853 to pay the director this £14,570, with a total tax paid of £1,283.

If the director were a sole trader instead, and had earned £15,853, they would pay 0.2*(£15,853-£12,570) = £657 tax on this income.

Now on any further dividend income the director wishes to take, they will pay at least 8.75% tax. This is after the company paying 19% on the profit. As a sole trader, they would pay 20% at basic rate (albeit without the £2,000 dividend allowance).

I know this is supposedly a tax-efficient system, but I am failing to see the benefit here. Obviously, they would take the NI efficiency into account; is this really the only efficiency in limited vs sole?

Replies (18)

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By Andy556
25th Apr 2022 20:30

I doubt many people would advise somebody earning £15,000 to set up as a limited company as the benefit is minimal if anything. (Without taking into account personal circumstances etc)

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Replying to Andy556:
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By Rosefield
25th Apr 2022 20:34

Thanks, yes of course you're right about that.

I should have scaled up further. Suppose we go to a business with turnover of £60k and expenses of £20k or so. It still seems to me that the director cannot really draw a proper income as dividends without incurring more in taxes than they would as a sole trader. Since the company tax due is 19% and then there's a further 8.75% personal tax. I must be missing something obvious, but I don't see the tax benefit purely in those terms.

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Replying to Rosefield:
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By Alex Perkin
25th Apr 2022 21:25

Rosefield wrote:

I must be missing something obvious, but I don't see the tax benefit purely in those terms.

National Insurance?? Your calculations should be...
20% + 9% + £3 p/w = 29% + £3 p/w
vs
19% + 8.75% = 27.75%

I agree with you that the gap between Ltd v S/T has significantly narrowed in the last few years.

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Replying to Alex Perkin:
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By Rosefield
25th Apr 2022 21:48

Thanks, yes that confirms my thought that NI is the only real benefit as far as this level of efficiency in a very simple example. That's just a surprise to me as I have read a lot about the tax efficiencies of limited companies so assumed there would be more to it than just NI savings.

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Replying to Rosefield:
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By rmillaree
26th Apr 2022 08:56

"Thanks, yes that confirms my thought that NI is the only real benefit"

There are other benefits - eg extra tax/ni relief on pension contributions can be a saver - avoiding paying 10% ni on profits syphoned into pension compoared to sole trader.

The main elephant in the room on top of the useful marginal saving is the saving once you start to bubble on the higehr rate tax band - even then though the tax planning is complex as higher rate taxpayers can end up with higher marginal rate via company structure.

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Replying to Alex Perkin:
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By D V Fields
25th Apr 2022 21:49

…. and limited liability could be worth a bob or two.

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Replying to Alex Perkin:
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By Paul Crowley
25th Apr 2022 23:02

not 27.75%
the dividend tax is calculated after tax, so is 8.75% of 81% on net profit
Hence it is 19% +7.1% = 26.1%

Percentages need to be of the correct start point

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Replying to Rosefield:
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By DKB-Sheffield
25th Apr 2022 21:47

As Alex has said (albeit slightly incorrectly given the current rate of Class 4 NIC is 10.25% for SE) you are forgetting NI! This is so often overlooked but, it is a TAX on income. You should also remember in the current year NIC for self-employed 'kicks in' at £9,881, so the 10.25% is payable on £2,689 more income than tax.

There are, however, many more reasons to consider incorporation! Tax efficiency should only ever be one reason and should NEVER be the sole motivation!

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Replying to DKB-Sheffield:
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By Rosefield
25th Apr 2022 21:56

Thanks for the reply. I did mention NI in my post but I was just curious if I have got the tax implications straight. NI is rather more straightforward as it's an all or nothing for sole vs limited (at least with this set up)! I thought the other tax benefits would be more substantial, so just wanted to see if I'd understood correctly.

And of course you're right that there are other considerations, all of which still point towards limited as a more suitable option for many ventures. I was just wondering if remaining sole trader means my hypothetical director is throwing away tens of thousands a year in taxes, but it seems like that's not the case.

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Replying to Rosefield:
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By DKB-Sheffield
25th Apr 2022 23:25

NI is never to be taken lightly! It's often NI that makes the real difference! Be it that additional pesky tax charge, or the relatively lower NICs paid by those in 2 P/T jobs!

I actually subscribe to the argument that dividend 'tax savings' have long been dividend 'NI savings' and not 'Income Tax savings' at all. Before 2016, the marginal IT + CT rates were 'more approximately' aligned with the progressive tax rates but had very little in the way of 'NI'. The introduction of the new dividend tax rates in 2016 brought those tax levels up to 'compensate' for some of the lost NI.

On missed opportunity... You probably won't find £10Ks, or even £1Ks of tax savings in a predictable 'fixed' trade. However for trades who see bienial/ trienial profits (e.g. property development, large event companies, touring musicians) the flexibility of declaring dividends in 'down years' can save a small fortune - in addition to the limited liability (etc.) aspect!

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By Paul Crowley
25th Apr 2022 23:26

Tax efficiency
It goes the other way once company income increases
CT becomes 26% over £50,000 fairly soon, (on the margin).
NI for self employed drops to 3% when over the limit

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By gillybean04
26th Apr 2022 00:20

Remember there's other things to consider than the rate of tax or NI.

Dividend nil rate, for instance. Or being able to control when you receive the earnings, and how much you receive (and potentially retaining entitlement to certain benefits).

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Replying to gillybean04:
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By Matrix
26th Apr 2022 05:08

Agreed that timing of profit extraction is an advantage and the main tax planning tool for my clients.

Not distributing or declaring profits for benefits purposes is benefits fraud so what do you mean?

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Replying to Matrix:
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By rmillaree
26th Apr 2022 10:19

Guessing gillybean04 meant exactly what they said - you have some flexibility here ref timing of income EVEN if you are claiming some benefits. the fact there are "anti avoidance rules" in place doesnt mean that there can be no advantage gained ref timing - one just needs to be sure one is staying within the rules if one is claiming benefits.

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Replying to rmillaree:
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By Matrix
26th Apr 2022 16:11

I don’t think this point belongs on this thread. When is it OK not to declare notional income and defraud the treasury?

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By SteveHa
26th Apr 2022 08:28

You seem to be letting the tax dog wag the tail. Tax efficiacy should not be the driver behind whether or not to incorporate.

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ALISK
By atleastisoundknowledgable...
26th Apr 2022 09:55

Everyone’s (temporarily) forgetting about MTDITSA’s 5 tax return pa. The digital record keeping might tip things slightly towards ltd for the smaller/older clients.

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Replying to atleastisoundknowledgable...:
paddle steamer
By DJKL
26th Apr 2022 11:51

Until Limited companies also get within the event horizon (no doubt eventually) and they too get sucked into the MTD black hole.

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