The choice of vehicle for operating a business is an important one. The coronavirus crisis and government support for businesses has brought some of the distinctions in trading vehicle into sharp focus.
The choice of trading vehicle includes trading as a sole trader, in partnership, as a limited liability partnership (LLP) or limited company. There are a number of factors to take into account and in particular whether limited liability is important, profit and loss expectations and the extraction of profits among others. A sole-trader or partner will pay tax and national insurance contributions (NICs) on his profits – but the after tax funds are his to draw on free of further taxes.
A company will pay corporation tax on its profits (currently at 19%). A shareholder can receive a share of the after tax profits by way of dividends on which he or she will pay income tax at a special tax rate (0% on the first £2,000, 7.5% / 32.5% or 38.1% depending on income levels). There are no NICs on dividends, which is a primary reason that these dividend tax rates have become less generous in recent years.
A director will pay income tax on salaries drawn and well as NICs. The company may also pay employer’s NICs on the salary payment to directors. It has historically been commonplace for a director-shareholder to be paid a fairly low salary, perhaps within the NIC limits and also receive larger dividends. One of the consequences of this approach is a low NIC liability for the individual and the company, as well as lower income tax on the dividends than would be paid on an equivalent salary.
However, with the furlough grant being payable in respect of earnings, if a company furloughs a director it is restricted to being based on the salary and not the dividend element (which is a share of profit not earnings). Typically this may fall far short of what the director/shareholder usually receives from the company as part of his total receipts from salary and dividends. It should also be noted that the self-employed income support scheme (SEISS) does not apply to companies and seems more generous to business owners.
I understand that there is an online petition that at the time of writing has attracted over 300,000 signatories which appears to be director/shareholders stating that they believe their dividends are earnings and should attract the furlough grant (up to the £2,500 per month limit).
I would urge caution in making such a contention. Earnings should be taxed under PAYE at rates higher than for dividends, and attract NICs for both the employee and employer. In many cases the salary and dividend arrangements have been in place for many years. Given the desire of HMRC to open enquiries to argue that dividends are in fact earnings and so liable to NICs then anyone signing the petition and providing their name and address could be asking for trouble. It could be viewed as an own goal, and I would not be surprised to see HMRC raising a very large number of enquiries on this point in future. As ever, the importance of doing the documentation correctly is key.
These are difficult times but an understanding of the distinction between dividends and salary remains very important from both a legal and tax perspective. Be careful what you wish for.
Family Business Connect
If you have a family business and are concerned about this or other business matters, related to coronavirus or just in general, our team use our own advisory platform, Family Business Connect when talking to our clients. With over 350 other areas that our advisers can discuss with a family business we look forward to being able to work through Family Business Connect in a structured way, depending on your own individual circumstances.
At PKF Francis Clark, we have a wealth of experience, having worked with family businesses of all sizes for many years. We look forward to hearing from you.