In 2004 the Chancellor introduced tax dividends for small businesses. Described as a measure to stop the self-employed incorporating to avoid paying tax, the Chancellor neutralised the 0 per cent band of corporation tax profits at £10,000. This now applies unless a company chooses to re-invest its profits back into its business.
A distribution from a company is anything that the company gives to one of its shareholders without the shareholder giving full payment in return, with the most common type of distribution being a dividend: a cash distribution of the company’s profits. In the distribution of your company's net profit after corporation tax, dividends represent the amount of profit paid to shareholders. The balance is generally retained as profits of the business.
When paying dividends, a company must send a dividend voucher to the shareholder by post, showing the amount of the dividend and the amount of tax credit. The tax credit shows the amount of tax paid by the company on the shareholder's behalf: dividends are paid after tax has been deducted at the basic rate. Companies may pay dividends electronically if a shareholder agrees to it and in such cases no longer need to send a dividend voucher.
Small limited companies have to pay tax on dividends: currently, corporation tax is at 21 per cent, increasing to 22 per cent from April 2009. A small amount of relief is available if you do not distribute all your profits in the tax year.
For a small company, financial year end April 2009, any amount of money not taken as salary is subject to corporation tax liability at 22 per cent. However, if salaries taken fall below the higher threshold, the company could save 12.8 per cent on national insurance at the same time. This would reduce the net tax effect on the company to just 9.2 per cent
It is believed that dividends tax will remove any tax savings on re-investment further down the line, so in effect entrepreneurs will pay at least 22 per cent on all company profits in the long run.
Is it still worth being an incorporated business?
The tax benefits of being a limited company were cut down by the 2004 Budget, and many small firms felt aggrieved that after encouraging them to incorporate a few years ago, the chancellor was looking to ‘trap’ them in a dividends tax.
Despite this, in terms of taxation it is still better to be a limited company than a sole trader in most circumstances.