Tax Q&A: The tax position of small business owners

The hike to the tax rate on dividends from April 2022 has dismayed some small business owners. What are the options for those affected?

Q: A few clients have come to me about this since the Budget in October. What’s the background here, please?

The tradition of small business owners – where they are operating through a limited company – paying themselves (at least partly) via a combination of a relatively small salary and dividends, has been well-established over many years and continues to be a popular way for owner directors to take their earnings from a business.

However, some owners and commentators have suggested that – with the planned increase in dividend taxation from April 2022 onwards and the issues associated with the furlough scheme (which did not cover dividend income) – that it is not actually the “best way” for owners to pay themselves.

Q: How do the methods compare?

Firstly, it is important to understand how the overall tax burden is, when a business owner is paid in different ways. The below examples using the 2022/23 rates provide a simple breakdown of the position for a business where the profits are £50,000 in the first instance.

• Self-employed individual – net income after income tax and NICs (class 2 and class 4) – £38,238.
• Owner-director with a salary of £9,000 and the remaining net profit withdrawn as dividends – net income after corporate tax, dividend tax etc. – £39,767.
• Owner director paying themselves fully via salary – net income after PAYE and employee and employer NICs – £33,563.

Hence, we can see that the owner-director being paid partly via salary and partly via dividends remains the best overall tax approach, regardless of the planned increases in dividend tax rates. Longer- term, however, the planned increase in corporate tax rates to 25% (from April 2023) may change this balance.

This looks at the position from a “simple” tax perspective. The recent Covid-19 pandemic and the schemes that the government introduced to support the “self-employed”, didn’t provide any support for business owners paying themselves via dividends.

Hopefully the worst of the pandemic is behind us and we won’t need any furlough support (or similar schemes) in future. It is certainly still reasonable for advisers to highlight the furlough experience as a “risk factor” when business owners are deciding how they should structure their businesses.

Q: So how can that be improved on?

Though a mix of dividends and a smallish salary do offer more tax efficiency than simply being self-employed or being an owner-director who is paid totally through a regular salary, it is sensible to consider whether any other options are even more tax efficient for the owner-manager. In this regard, there are two obvious options to consider using:

• Retaining the money in the company and then eventually taking out the money as a capital gain; and/or
• Taking the money out on a shared basis (e.g. with a civil partner or a spouse).

The main advantage of taking the money out as capital gains – e.g. on the eventual sale of the business – is that the CGT rate on business sales is only 20%. Indeed, assuming the owner qualifies for Business Asset Disposal Relief, the tax rate could be as low as 10% on qualifying disposals.

However, while the low CGT rates can be attractive, advisors should not forget some key, wider points. For example, can the client afford from a cash flow/cost-of-living perspective to simply keep retained profits in the business on a “long-term” basis? You may find that this isn’t a realistic option for many owner-managers.

While CGT rates are attractive at the moment compared to income tax rates, we should not assume this will always be the position.

It is quite possible that a UK government could equalise income and capital gains tax rates at some stage in the future. What would that mean for your client?

Q: Are there tax savings elsewhere?

While the recent budget has increased taxes overall – and these tax rises will, realistically, continue to increase over the next 4-5 years as many allowances and rate bands will, at the very least, be frozen – business owners and their advisers should also consider the impact of any tax reliefs and easements that are available. For example, it is possible that business rates relief may in effect offset the increase in the dividend rate of tax and the freezing of income tax bands, at least in the shorter-term.

Other businesses may find that they could move to freeports and benefit from some of the investment reliefs that the government has announced for these areas (e.g. potential NIC savings for staff working at least 60% of their time in a registered freeport).

Q: Are there other factors to consider?

It is very easy for clients and their advisers to focus purely on the tax costs of particular business structures and look to minimise these. However, as a business adviser to clients, it is important to consider whether there are wider factors that may be relevant. For example:

• Could your client’s business be caught by the IR35 regulations? If so, their earnings may automatically become subject to PAYE and NIC withholdings on a going forward basis.
• Does your client want to keep things as simple and straightforward as possible, even if this isn’t as tax efficient as it could be? If so, being self-employed may be the most appropriate option for them.
• Do they like the limited liability that comes from operating via a limited company (or an LLP)?
• What do clients want from their business? You may find – especially if the client is interested in growing the business significantly – that they need to register as an LLP or a limited company, as this is what clients expect.

Q: Can you sum this up?

Business owners and many in the general public are facing a period of tax rises over the coming years. It is quite possible that these tax rises will be combined over the next year or two with increased inflation and higher interest rates in a type of “triple whammy” for businesses and their owners.

As such, it will be appropriate for advisers to work with business owners to try and ensure that they retain as much of the value that they are creating, as is legitimately available. Such discussions with clients need to be part of a rounded discussion focussing not just on the tax issues, but also on their wider position.

If you would like to discuss any of the above, please get in touch with Robert Salter using the details on this page.

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