Where there are several shareholders, for 2015/16 profits can be extracted tax-free by paying dividends to each up to the basic rate limit. Where shareholders have other income, the best result is obtained if the gross dividend is equal to the unused portion of their basic rate band.
However, unlike salary there is no flexibility to choose how much to pay each shareholder as dividends must be paid in relation to shareholdings. However, this restriction can be overcome by having different classes of shares for each shareholder so the dividend paid to each shareholder can be tailored each year.
Note – this strategy will not apply for 2016/17 onwards as the taxation of dividends is being reformed. From that date, the 10% tax credit is being abolished and taxpayers will receive a tax-free allowance for dividends of £5,000. Above this level dividends will be taxed. Consequently, from 2016/17 dividends can only be paid to shareholders tax-free up to £5,000 once the personal allowance has been used.
DEF Ltd is a family company. Nick and his wife Rachel are shareholders and directors. Nick holds 100 A shares and Rachel holds 100 B shares.
In 2015/16 Nick has other income of £10,600 and Rachel has no other income. The personal allowance is £10,600.
Paying Nick gross dividends of £31,785 will take his income up to the basic rate limit of £42,385 for 2015/16. This is a net dividend of £28,606 or £286.06 per share.
As Rachel has no other income, she can receive gross dividends of £42,385 before paying any additional tax. This is equivalent to net dividends of £38,146 or £381.46 per share.
By declaring an A class dividend of £286.06 per share (net) and a B class dividend of £381.46 per share (net) the dividends can be tailored to utilise the remaining basic rate band and personal allowances of both Nick and Rachel.
It should be noted that Rachel cannot reclaim the 10% tax credit attaching the dividends covered by her personal allowance.