Dividends and the impact on incorporation for law firms
The Chancellor, George Osborne, announced in the Summer 2015 Budget a shake-up in the way dividend income is taxed from April 2016. As the announcement has added to the complexity of the current dividend system the reaction has been, unsurprisingly, one of confusion over how the new tax will work in practice. The changes again raise the question of incorporation for law firms. The default model for a solicitor practice was historically the partnership structure, yet, in the last few years, the take up by law firms adopting the LLP model has been particularly impressive. Full incorporation can bring benefits to a law firm – as we have covered in our pros and cons guide to solicitor incorporation – but the recent changes to the way dividend income will be taxed is set to reduce the tax advantages of incorporation for many law firms.
How will the new tax work?
Following the announcement, all taxpayers will have, when the new tax comes into effect, a tax-free dividend allowance of £5,000 a year. The first £5,000 of dividend income in each tax year will be tax-free, and dividend income above this allowance will be taxed at 7.5% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers. This will replace the current system, where those receiving dividends benefit from a tax credit. The tax credit means that basic-rate taxpayers are currently taxed at 0%, higher-rate taxpayers at 25% and additional-rate taxpayers at 30.6%.
The changes are highlighted in the table below:
It is also worth noting that the allowance will not completely exempt £5,000 of dividend from tax. Although no tax will be charged on the first £5,000 of dividend income, it will still count towards total income in determining which tax band applies to any additional dividends.
Will all individual taxpayers be worse off under the new regime?
No. While it’s true that the new system will see many pay more, a new £5,000 allowance for all taxpayers and the removal of tax credits will create both winners and losers. The biggest losers may be those basic-rate taxpayers who receive more than £5,000 in dividends a year, large-scale investors and business owners who currently mix their remuneration between salary, bonus and dividend. The winners, on the other hand, will be small-scale investors who receive less than £5,000 dividends in a tax year and higher-rate taxpayers who have a dividend income below £21,667.
We have provided some examples at in a recent article on the new dividend changes.
Is incorporation for law firms still worthwhile?
These changes will reduce the tax advantage of taking dividends rather than salary, but for most law firm owners it is still likely to be marginally more efficient. If your law firm currently operates using a limited company structure then now is a good time to review the planning and timing of your remuneration and profit extraction strategies. If you do not operate using a limited company structure then these changes will not affect you, but whether or not incorporation is still worthwhile is still a relevant question.
In addition to the dividend income shake-up the Chancellor also announced further taxation changes which are likely to impact the tax advantages for law firms who incorporate, including changes to entrepreneurs’ relief and corporation tax. These significant and continued changes will further impact the attractive tax planning opportunities for law firms operating using a corporate structure.
Whether or not incorporation for law firms is still worthwhile will depend on specific circumstances and whether it works for your firm is something only you and your fellow partners can decide. It is also important to note that when deciding whether incorporation is the right route for your firm, you must also consider other factors as well as tax, such as limited liability, pension arrangements and exit strategies.
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