Income Taxes and Dividend Taxes

An income tax is a tax levied on the financial income of persons, corporations, or other legal entities. Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate tax, corporate income tax, or profit tax. Individual income taxes often tax the total income of the individual (with some deductions permitted), while corporate income taxes often tax net income (the difference between gross receipts, expenses, and additional write-offs).

The "tax net" refers to the types of payment that are taxed, which included personal earnings (wages), capital gains, and business income. The rates for different types of income may vary and some may not be taxed at all. Capital gains may be taxed when realized (e.g. when shares are sold) or when incurred (e.g. when shares appreciate in value). Business income may only be taxed if it is significant or based on the manner in which it is paid. Some types of income, such as interest on bank savings, may be considered as personal earnings (similar to wages) or as a realized property gain (similar to selling shares)

Tax rates may be progressive, regressive, or flat. A progressive tax taxes differentially based on how much has been earned. For example, the first $10,000 in earnings may be taxed at 5%, the next $10,000 at 10%, and any more income at 20%. Alternatively, a flat tax taxes all earnings at the same rate. A regressive income tax may tax income up to a certain amount, such as taxing only the first $90,000 earned.

Taxation of Small Business Profits

There has been loads of changes in the rates of taxation which small companies are liable to pay. As of the present day the rates are as follows:

Taxation for small businesses in UK since April 2006

Level of Profit Tax Rate
£0 to £300k 19%
£300k to £1.5m Marginal rate from 19% to 30%
£1.5m and above 30%
Income tax personal and age-related allowances
£ per year (unless stated) 2007-08
Personal allowance (age under 65) £5,225
Personal allowance (age 65-74) £7,550
Personal allowance (age 75 and over) £7,690

The government provides a ‘tax credit’ amounting to 10% of dividend income for shareholders, to take account of the fact that dividends are paid out of already taxed profits. So when your dividend is issued you will receive a statement showing both how much was paid and the tax credit due.There are two levels of tax on dividends. Basic rate taxpayers are taxed at 10%, which is covered by the tax credit issued, so there is no further tax to pay. Higher rate taxpayers pay 32.5%, minus the 10% tax credit, 22.5%.

Income tax rates in UK 2007-2008
Rate Tax Rate

Band (above any personal allowance)

Starting rate 10% 0 - £2,230
Basic rate 22% £2,231 - £34,600
Higher rate

40%

over £34,600
Dividend tax rates in UK 2007-2008
Dividend income that falls Tax rate
below the £34,600 level 10%
above the £34,600 level 32.5%

It is not uncommon for a controlling director to have a remuneration package that consists heavily of dividend payments. Dividend payments are distributed from the net profits of a limited company and are paid net of a 10% tax credit. If the shareholder is not a higher rate taxpayer after taking into account the gross dividend, then no further tax is due. If any part of the gross dividend falls within the higher rate tax band then income tax is levied at the rate of 22.5% on that part of the gross dividend.

At the end of the tax year, most small business owners pay 19% taxes on their profits and then receive the rest of the income in the form of dividend payments. This dividend then is not double taxed, if the dividend amount is below the higher dividend tax level (£34,600). The dividends which are below this rate do not require to be taxed again, however they require to be shown in the financial reports notionally.

Nothing is better than giving an example. So assume that there are two partners owning a company having a share 50% each and liable to pay taxes on £100K of profit at the end of the year. The amount of the tax they need to pay is 19K as it is under £300K. Then the rest can be shared as £40.5K each in the form of dividend, which requires to be taxed, since it is above the higher dividend tax rate. The amount they need to pay from this income is 22.5% of (£40.5K - 5.225K) = £7.93K.

Note: Marginal tax rate is the highest rate at which you pay it. In other words, if you are a basic rate taxpayer only, and you have sufficient unused basic rate band after taking into account all other income then you will pay tax at 22%. If you are a higher rate taxpayer then you will pay tax at 40%. You may find yourself paying some tax at 22% and some at 40%, ie if the additional taxable income exceeds what is left of your basic rate band.

References

1. http://www.jameshay.co.uk/KnowledgeBase/Features.aspx?id=89

2. http://money.scotsman.com/scotsman/articles/articledisplay.jsp?section=Tax&article_id=1040591

3. http://www.direct.gov.uk/en/MoneyTaxAndBenefits/Taxes/TaxOnSavingsAndInvestments/DG_4016453

4. http://en.wikipedia.org/wiki/Taxation_in_the_United_Kingdom

5. http://www.taxationweb.co.uk/forum/discuss.php?id=9304

3 comments:

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