Major change to taxation of dividends: A business guide

The taxation of dividend income has always been treated differently from other income types, but in the Summer Budget in July the chancellor announced a major change to how dividend income will be taxed. Emily Coltman FCA, chief accountant to multi-award-winning online accounting system FreeAgent, explains what this change is and how it will affect small businesses.

Until April 2016

At the moment, dividends are treated as though you, the shareholder, have already paid basic rate tax on them. That means that if your total earnings from your business and any other sources are under £42,385, you won't pay any more tax on your dividend income.

If your earnings are over £42,385 but under £150,000, you're a higher-rate taxpayer and will pay income tax at an effective rate of 25% on any of your dividend income that's over the £42,385 level. So if you take a salary of £10,600 and the company also pays you £40,000 in dividends, you'll pay tax on £8,215 of your dividends (£10,600 + £40,000 - £42,385).

If your earnings are over £150,000, you're an additional-rate taxpayer and will pay income tax at an effective rate of 30.56% on any of your dividend income that's over the £150,000 level.

From 6 April 2016

From 6 April 2016, dividends will no longer be treated as having already been taxed. Instead, the first £5,000 of any dividend income you receive will be free of tax, then after that you'll start paying income tax on your dividends.

Dividends will be taxed at the following rates:

• 7.5% if you're a basic-rate taxpayer

• 32.5% if you're a higher-rate taxpayer

• 38.1% if you're an additional-rate taxpayer

This is likely to mean that if you operate through your own limited company and draw a small salary, taking the balance as dividends, you will pay more tax from 2016/17 than you have before. Depending on your circumstances and any other income you have, you may be paying at least £1,500 more tax than before.

What hasn't changed?

There will still be no National Insurance applied to dividend income; you pay tax on your dividends but not National Insurance.

Dividends on shares held in stocks and shares ISAs will still be tax free.

What should I do next?

If you're concerned about how these changes will affect you, talk them through with your accountant and find out whether there are steps you can take to mitigate them, such as leaving more money in your company or investing more in a pension fund rather than taking dividends.

This post is published in association with Legal & General.

For more tips on business protection and company set-up, download a free version of the Rough Guide to Work and Money.

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• The ins and outs of auto-enrolment pensions

• A guide to insurance protection for your small business

• Maternity pay: What employers and the self-employed need to know