The financial impact on you

The Limited Company which enters into contracts that pass IR35 will have the option of distributing some of the Company turnover as dividends. Dividends are technically a return on investment, paid to the Shareholders of the Company. The taxation advantage of dividends is that they do not attract National Insurance Contributions.

Alternatively, if the contract ‘Fails IR35′ the option of a dividend is severely restricted, with the bulk of the income being paid as salary and bonus; both resulting in full tax and NIC deductions.

Math’s for the IR35 Pass Contract
In cases where the contract ‘Passes IR35′ the Director will draw a regular salary from the Company. The expenses planning will also be maximized, incorporating items such as business travel, computer purchases, mobile phone bills etc. The balance of the Company funds are then accrued as profits, which can be distributed as dividends.

Here’s an example:

A Limited Company generates £400 per day from an assignment. This equates to around £100, 000 per annum. The Director elects to take a net salary of £2, 000 per month (equivalent to about £24, 000 per annum). In addition the Company will reimburse expenses of £5, 000 per annum, and the company will make pension payments, into the Director’s personal pension, of £5, 000 per annum. The math’s look like this:

Company Turnover £100, 000
Less: Salary £24, 000
Employer’s NIC £2, 300
Expenses £5, 000
Pension Payments £5, 000
 (£36, 300)
Company Profits (Pre tax) £63, 700
Corporation Tax (20%) (£12, 740)
Net Profit £50, 960
The £50, 960 can be distributed as a dividend to the Shareholders of the Limited Company. If, when this income is added to the Shareholders’ other income from elsewhere, the Shareholder remains in a lower tax bracket, there is no more tax or NIC to pay. On the other hand, if this dividend pushes the Shareholder into the higher rate tax bracket additional tax will be due. The most that this will ever result in is a further 20% (making the total tax deducted 40%).

In this example, if we assume that the Director is the sole Shareholder of the Limited Company; his (or her) income would be a salary of £24, 000 and dividend income of £50, 960. As higher rate tax usually starts when total earnings reach £42, 000, we can see that the first £18, 000 of dividends will be subject to no further deductions of taxes (£42, 000 less £24, 000 = £18, 000). The remainder of the dividend income (£50, 960 less £18, 000 = £32, 960) would be subject to higher rate income tax. Remember, dividend income does not attract NI deduction.

Also see the Guide To Dividends.

As can be seen by the above example, passing IR35 results in the ability to draw dividends; dividends do not attract NIC; so the yield for the Shareholder/Director is much greater.

Math’s for the Fail IR35 Contract

If the engagement that is the source of the funds has to be regarded as a Fail IR35, the Limited Company loses some of the control over the manner in which the income is paid out. In short, the income from ‘IR35 Fail’ engagements will need to go through the following process: –

Step 1 Calculate the company income from ‘employed engagements’ £100, 000
Step 2 Deduct 5% for ‘employer running costs’ £5, 000
Sub-Total £95, 000
Step 3 Deduct any expenses including business travel or PI insurance £5, 000
Sub-Total £90, 000
Step 4 Deduct pension contributions £5, 000
Balance (to be treated as payment deemed to attract Tax and Employers NIC) £85, 000
Step 5 Deduct Employers National Insurance (NIC) £9, 500
Gross Salary (subject to income tax and employee’s NIC) £75, 500
Although this is a bit complicated, you will clearly see that the amounts of NIC payable have increased significantly between the fail IR35 case and the earlier pass IR35 client.

It is, of course, quite possible to have a series of engagements throughout a tax year, some of which are regarded as ‘employment’ and some of which fall within the ‘self employment’ categories. In this case only the contracts that ‘Fail IR35′ are treated as above and income earned through other contracts being taxed under the “old rules”. Expenses in the circumstances are apportioned on a reasonable basis between the two types of engagement.

Your Figures
By now you will be starting to think about what this means in your case. To work out estimated figures for your circumstances click here

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