Struggling to understand tax efficiency...

[insomniac]

Hello,

My job was made redundant in September and I've managed to find a 6-month contract while I look for another position. It's my first time contracting, so am I'm struggling to understand the tax efficiency of working as a contractor.

In my case, by the time my redundancy came into effect I hit the higher tax threshold on my PAYE income for this tax year. So my accountant recommended that I do not collect a salary and instead take everything out of the company in the form of dividends.

Let's say that the company makes 100,000 in the year. After corporation tax, I can declare 80,000 as dividends. However, as I'm a higher rate payer, wouldn't I have to pay 25% dividend tax? If yes, then net of all taxes, I collect 60,000 on the gross amount of 100,000.

If my maths is correct, then the amount of tax I'm paying is actually 40%, which is higher, when averaged out, than what I'm paying on PAYE income. So how exactly does the tax efficiency work?

Thanks.

PS - I've used some round numbers and neglected the flat-rate VAT benefit for the sake of simplicity. Thank you.

[northernladuk]

Think about it in terms of a career lasting years without the complications of permie land and it shall all become clear. You are stuck in a one off situation so you are not seeing the clearer picture. It is tax effecient to run as a scheme on it's own. If you start introducing added complexity the picture changes completely...

Oh, and be a permie or a contractor. Don't mix the two please.

[scope]

For one you are not paying any NI on the dividend.. If it had been taken out as salary this would have to be paid. Im sure others will come along with better reasons.

[Clare@InTouch]

It's difficult because you've had so much income in the year to date, so it's skewed. You need to consider a full clean tax year, and then the tax efficiency can clearly be seen in the fact that dividends are tax free up to higher rates, and there's no NI on them.

You need to consider your strategy too. You're never going to be as tax efficient as possible if you withdraw every single penny you can - you may well be much better off just withdrawing up to higher rates, leaving the rest in the company, then closing the company via liquidation when you cease trading. This allows you to take a capital gain which would be taxed at lower rates than higher rate dividends would have been (if current rates of tax prevail, and assuming you have no other gains or have used up your Entrepreneur's Relief allowance already).

[Kelstar]

Go brolly and don't worry about it for now. If you are taking a contract to bridge your redundancy gap then setting up a Ltd will be a ball ache you could do without. 2 friends of mine are in the same position hence the advice.

Re: tax efficiency, someone will come along with calcs soon enough. But my 2cents is you are assuming you withdraw the entire amount as dividends. Holding money in the company not only reduce the tax hit upon withdraw (over the upper limit) but you also need to have money aside in case you are out of work. Which is common. That 6 month contract no doubt has a notice period when you might find yourself unexpectedly out of work.

[IR35FanClub]

If youve already earned over the higher rate threshold this year and are / would be in the 40% bracket, consider leaving the money you invoice for the rest of the year in your company until 2013/2014 tax year. Dont even take it as dividends this year as youll pay the higher rate tax on them. Pay the corpoartation tax at year end on it at 20something percent. The money will still be there next year. then Draw about £7500 in salary to make minimum ni payments of about £4 then draw the rest as dividends upto the 40% limit again. Any extra becomes you warchest. Ie rainy day money should you be on the bench for a while. If your war chest over a few years gets massive, consider expanding the busiess in new directions, taking a year off or retiring. lol. You never have to pay 40% tax if you dont take it from the company and are happy living on about £38k a year. I prefer to take long breaks between contracts than earning loads.

[northernladuk]

If youve already earned over the higher rate threshold this year and are / would be in the 40% bracket, consider leaving the money you invoice for the rest of the year in your company until 2013/2014 tax year. Dont even take it as dividends this year as youll pay the higher rate tax on them. Pay the corpoartation tax at year end on it at 20something percent. The money will still be there next year. then Draw about £7500 in salary to make minimum ni payments of about £4 then draw the rest as dividends upto the 40% limit again. Any extra becomes you warchest. Ie rainy day money should you be on the bench for a while. If your war chest over a few years gets massive, consider expanding the busiess in new directions, taking a year off or retiring. lol. You never have to pay 40% tax if you dont take it from the company and are happy living on about £38k a year. I prefer to take long breaks between contracts than earning loads.

He is a permie taking a contract gig before getting a new job.

[insomniac]

Thank you for the useful feedback. I think that's exactly the situation I'm in - my PAYE income for the year has skewed the tax efficiency of the contract.

So far I haven't taken any money out of the company at all, and I probably won't - the weather forecast is clear for now, but that's apt to change no doubt.

Appreciate all the help and advice.

[Wanderer]

my PAYE income for the year has skewed the tax efficiency of the contract.

So far I haven't taken any money out of the company at all, and I probably won't - the weather forecast is clear for now, but that's apt to change no doubt.

Yes, you are on the right track. Hold the cash in the company for now. From April 6th you can draw £7488/year salary and ~£32k dividends from your profits (after 20% corp tax is paid).

Alternatively, you could put the money into a pension, use it to start up a business or close the company down and take it as a capital distribution at a much lower tax rate.

[Jessica@WhiteFieldTax]

Go brolly and don't worry about it for now. If you are taking a contract to bridge your redundancy gap then setting up a Ltd will be a ball ache you could do without. 2 friends of mine are in the same position hence the advice.

Yep, although it does the accountants out of business, that's what I would recommend in these circumstances. Don't set up your own company unless its a long term venture - although I get the impression that she has already sailed