Contractors who use their own contractor limited company can maximise their tax efficiency by paying themselves a low salary and taking additional remuneration from their business in the form of dividends.
However, contractors also need to seriously consider numerous other factors. These include exactly how much dividend they should pay themselves, when to raise the dividend and when to pay it. By being diligent and paying close attention to these details, a contractor can maximise their tax efficiency and reduce their risk of attracting unwanted attention from HMRC.
Calculating dividends
The first step in dividend management is to calculate how much of a dividend can be paid. Dividends can only be paid out of the profits of a limited company, and if the company is not making a profit then it should not be paying a dividend.
Good management accounts will be able to tell a contractor how much profit there is in the business at any given time. In order to stay below HMRC's radar, contractors are advised to calculate the minimum cash they need to live on, the maximum amount of dividend the profits in the company will allow, and pay themselves something between the two.
They should also take into consideration their dividend tax planning when considering the amount of dividend to pay. This will help make sure that they don't unwittingly withdraw an amount that lands them in a higher taxband, whilst also ensuring that they retain a comfortable amount within the company. In other words, they should either have a management system that tells them how much they have earned in the fiscal year or have regular conversations with their accountant.
One word of warning for contractors. Avoid what are known as ‘ultra vires’ dividends, This is when a dividend has been paid when it should not have been, typically when there is not enough profit in the company to do so. If a contractor is found to have knowingly paid out an ultra vires dividend, they could be liable to repay it.
It’s all about timing
Contractors are able to raise dividends and pay them separately, which can sometimes work to their advantage. 'Raising' a dividend is an accounting exercise which affects the profit and loss account of the business, whereas 'paying' a dividend only concerns the cash flow.
That means a contractor can raise a dividend, which is an exercise in dividend paperwork, but does not have to actually pay the dividend. This can be useful in the instance that they may not be able to pay the dividend because there is not at that time enough cash in the company.
For instance, a contractor company may still be owed money from a client, meaning the company cannot pay out a dividend. In this case, a contractor can raise a dividend and not pay themselves, becoming a creditor in the process. When the company receives the money from the client, it is free to pay the dividend.
Tax allowances
Another example of when a contractor may wish to raise a dividend, but not pay themselves immediately, is on 31st March at the tax year end. For example, a contractor may not have used their full lower rate tax allowance. In which case, declaring a dividend before the new tax year which keeps them within the same tax band increases tax efficiency.
Assuming the company was profitable enough to do this, the contractor would be able to use the full extent of their lower rate tax band and pay themselves when the company had the cash.
Dividend frequency
If contractors are generating profits on a regular basis, it is perfectly reasonable for them to raise and pay a dividend on a periodic basis. However, a contractor making a regular monthly dividend of the same amount from irregular income and profits could be challenged by HMRC to be paying themselves a salary.
And the converse is true – if the contractor limited company has a regular stable income, with regular profits, and the contractor pays themself a regular dividend (but as before between the minimum cash the contractor needs and the maximum dividend that could be paid), HMRC would have difficulty challenging this on any reasonable grounds.
However, contractors need to beware to steer clear of standing orders and direct debits, both of which could catch the attention of the taxman. Ideally, contractors should make three separate payments to themselves each time they do make a payment: expenses, salary and dividend, with each accounted for separately. This will help to ensure that HMRC has no reasonable grounds to take the contractor to task.
Dividend waivers
Some contractors may have heard on the grapevine that dividend waivers are a good wheeze, allowing contractors to shift their dividend payments onto their spouse to save tax.
This is not the case. Especially since a recent ruling, Buck v Revenue & Customs, whereby HMRC clearly demonstrated that it considers dividend waivers in limited companies to be potentially a settlement. As a result, it is largely considered a means of avoiding tax.
Contractors trying this one on will find themselves given short shrift by HMRC, and are likely to gain little sympathy from their professional advisers when a large tax bill arrives on their mat.