29 Mar Why budgeting is beautiful for small business owners!
An important theme from the Spring Budget is that the government can’t seem to balance its own books! Even after years of cuts to public services, the nation still spends around £60 billion a year more than it earns and the debt we expect to pass on to the next generation continues to grow.
Source: Office of Budget Responsibility, 2016/17 forecast. Pie chart available at gov.uk.
To plug this hole in the nation’s finances, the Chancellor is attempting to rob Peter to pay Paul. Sadly, the Peter in this case appears to be business owners.
When George Osbourne’s new dividend tax took effect in April 2016, the dividend allowance of £5,000 was a little sweetener for many small business owners. This meant the first £5,000 of dividend income in each tax year will be tax-free. Amounts above this are taxed at 7.5 per cent for basic-rate taxpayers, 32.5 per cent for higher-rate taxpayers and 38.1 per cent for additional-rate taxpayers. Bear in mind that the dividend tax, is in addition to the corporation tax already paid on company profit (typically at 20% for small companies with profits under £300,000) before being distributed to the owners of the business.
Sadly, Chancellor Hammond now plans to a significant reduction to the dividend allowance, from £5,000 to £2,000 from April 2018.
In effect the reduction from £5,000 to £2,000 dividend allowance will mean paying 7.5% income tax on another £3,000 from April 2018, which equates to £225 per share holder per annum.
The political thinking was that the dividend allowance benefitted the rich; those who had large equity portfolios. There was no differentiation between this and the small business owners wanting to remunerate themselves in the form of dividends. The government could easily have differentiated between the two! Therefore, not only do owners of limited companies remunerating themselves in the form of dividends lose out, so do those who have large equity portfolios (comprising stocks and shares or collectives/ funds) directly held. Granted you have to have a rather large portfolio to receive income of more than £2,000 per annum.
The implication of this is that small business owners need be more savvy and intentional in their business and personal cashflows. As the old saying goes, “if your outgoings exceed your income, your upkeep will eventually become your downfall.”
For business owners, budgeting is about anticipating expected revenue, expenses and likely profit. This enables you to structure when and how you draw profit from the business in the most tax efficient way.
Let’s take a hypothetical case of John Doe, a sole director of his own IT company (called John Doe Ltd), with an anticipated turnover of £100,000 in the year 2016/17. By planning in advance, John could take an annual salary of £8,000 (to stay just below the threshold for paying NI, while keeping his entitlement to future state pensions and benefits), which together with other business expenses such as travel, mobile phone bills and other costs are typically tax-deductible business expenses.
Together with his accountant, John could work out his anticipated profit and corporation tax for the trading year. This enables him to have a far more robust dialogue with his financial planner about likely ways reduce his taxable profit, for instance by making pension contribution of say, £12,000 p.a. and arranging protection policies (for income protection and life insurance) through the company. If John’s spouse is involved in the business, even if in a small capacity, there may be scope to pay them a small salary (typically to utilise their personal allowance) and make pension contributions for them.
Suppose John expects to draw £36,000 in dividends, the chart below provides a visual image of what John Doe’s company projected cash flow might look like;
Armed with this information, Mr John Doe is in a far better position to plan his personal cashflow. This is crucial, particularly in the context of the recent and proposed changes to dividend tax. The chart below gives an idea of what John’s personal income tax liability could look like in 2017-18.
The real beauty of budgeting is that John can be a little more deliberate about his finances by breaking down the numbers and setting up monthly contributions to his pension and set aside funds to pay his tax bill when they fall due.
Clearly, this is just a hypothetical example and everyone’s circumstances are different. Our intention isn’t to tell you how to spend your money but to help you make the most your finances, whilst minimising taxation. There is nothing illegal about minimising or mitigating tax (as long as this is done legitimately).
We encourage our clients to have the conversation before the start of each trading year, rather than at the end. If this is relevant to you, please let us know. We’ll be happy to discuss and/or facilitate a conversation with your accountant, if necessary.