Salaries and Dividends
Many small business owners find allocating money between dividends, salary and expense claims difficult and complicated.
The Basics
Small company owners are normally both directors and shareholders in their businesses. A director is an employee, and thus entitled to a salary, whereas a shareholding is an investment and thus entitled to a dividend. But whats best for tax purposes?
Historically the tax/NI on dividends v salary wasn’t that different, however the Dividend Tax introduced from 16/17 onwards makes dividends 7.5% more expensive. The big difference however is National Insurance – which doesn’t apply to dividends but does apply to salaries at a marginal rate of up to 25.8%. Subject to IR35 considerations a low salary / high dividend is normally preferred to save NI.
In terms of taking money out of your company, your first priority is settling expenses that you’ve met personally, eg mileage, travel, subsistence – these will be tax free.
Second priority is salary – normally to somewhere around the Personal Allowance level.
Finally, dividend covers the rest of your available profit, or you can leave profit in your company as a buffer. Dividends are paid from company profits after Corporation Tax and and are taxed as personal income via Dividend Tax.
Always make sure tax (PAYE/NI, Corporation Tax and VAT) is provided for and kept separately in the company.
Salary levels
There are no rights and wrongs relating to salary levels, however too high a salary level results in unnecessary NI being paid. Issues to consider are (2018/19 rates):
- NI costs – the threshold is £8,424 for employees NI at 12% and for employers NI 13.8% – below these levels there is no NI, over these levels there is
- Using or wasting personal tax allowance – £11,850 – from 16/17 dividends can be set against the personal allowance so this is less of an issue than before.
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- Accruing state pension / benefit rights – these start to at £6,032 of salary
- Funding personal pension payments – you can contribute up to 100% of salary to a pension fund, £40,000 maximum
- National Minimum Wage/National Living Wage – NMW/NLW doesn’t apply to company directors unless there is a formal contract of employment, which is unlikely. However some people prefer a NMW compliant level of salary – main NLW rate is £7.83 at present (April 2018), so £7.83 x 37.5 x 52= £15,268
- “Reasonableness” – no rights and wrongs, but some people feel a salary too low is provocative to tax authorities or unethical.
- IR35 – if income is caught by IR35 then your salary level set by this.
EMPLOYMENT ALLOWANCE
A key factor on the level of salary a director should get is whether the employment allowance is available for that director or not. The Employment Allowance was increased to £3,000 from £2,000 in 2016/17. But HMRC announced that from 2016/17 onwards the Employment Allowance would not be available to companies where the only employee paid earnings above the Secondary Threshold for Class 1 National Insurance contributions is the director. This means that companies with several employees, where the director is the only employee paid above the Secondary Threshold, will not be eligible for the Employment Allowance. Deliberately avoiding this restriction by adding a spouse to the payroll to meet the criteria will be open to challenge from HMRC.
However, if the spouse genuinely works in the business, then the company should be able to claim the Employment Allowance, subject to them having earnings above the Secondary Threshold for Class 1. If a company has two directors then entitlement to the allowance is maintained provided both of them are paid above the secondary threshold, and for directors the annual secondary threshold is £8,424 for 2018/19 (or pro-rata if the directorship began after the start of the tax year) would need to be applied to ensure the criteria is met.
In summary you can’t claim if:
- you’re the director and the only paid employee in your company
- you employ someone for personal, household or domestic work (like a nanny or gardener) - unless they’re a care or support worker
- you’re a public body or business doing more than half your work in the public sector (such as local councils and NHS services) - unless you’re a charity
- you’re a service company working under ‘IR35 rules’ and your only income is the earnings of the intermediary (such as your personal service company, limited company or partnership).
If you can claim the allowance there are three basic options to consider:
- Claim the Employment Allowance
- Take a salary up to the NI Primary threshold
- A tailored option where the director has other income or could generate interest to be paid from the limited company
Option 1: Claim the employment allowance
Where a director has no other income and the Employment Allowance will not be used up against other staff salaries then the most tax efficient option is to take a salary up to the Personal Allowance of £11,850 (£987.50 per month). The £11,850 salary will be tax free for the director, however Employee’s National Insurance of (£11,850 - £8,424 x 12%) £411.12 will be due. This is offset by a Corporation Tax saving of £11,850 - £8,424 x 19% = £650.94 (compared to paying a salary up to the NIC threshold), giving an overall saving of £239.82
Take an annual gross salary of £11,850 which is the standard tax free personal allowance for 2018/19.
This leaves you £34,500 of dividends to take. There will be some personal tax to pay on these though, as the first £2k is tax free but after that is charged at 7.5% tax:-
Gross salary £11,850
Dividends £34,500
Total £46,350
Class 1 Employee (£411)
Dividend tax (£2,438) £34,500 less £2,000 = £32,500 x 7.5%
Cash £43,501
Keep in mind however that dividends taken above the higher tax band will be taxed at 32.5%. And interactions with the child benefit charge, personal allowance withdrawal limit and the 37.5% tax band may occur where remuneration exceeds the above.
Option 2: Take a salary up to the NI primary threshold
If the director has no other income and the Employment Allowance will be used up against other staff salaries then the best option would be for the director to be paid a salary over the Lower Earnings Limit but under the Primary Threshold of £8,424 (£702 per month).
This leaves you £37,926 of dividends to take. As with option 1, there will be some personal tax to pay on these:-
Gross salary £8,424
Dividends £37,926
Total £46,350
Class 1 Employee NIL
Dividend tax . (£2,438) £37,926 less £5,426 = £32,500 x 7.5%
Cash . £43,912
*As you are taking £8,424 of salary this leaves almost £3,426 of dividends that are in the tax free personal allowance, as well as the £2k tax free for the dividend allowance.
The net cash after income tax and employees NI is slightly higher in option 2 than option 1 by £411, however this doesn’t factor in the additional corporation tax you save of £650.94 (£11,850 - £8,424 x 19%) on the higher Gross Salary in Option 1.
Option 2 also has the added benefit of reduced administration as no NI needs to be paid to HMRC.
Option 3: A tailored option
If the director has other income then a more tailored approach is required and one needs to consider the level and type of the other income, and also take into account whether the Employment Allowance will be used up against other staff salaries. Also, one should keep in mind that if the director is claiming the remittance basis, he will have lost the Personal Allowance and the benefit of a salary becomes then questionable.
But not everything is tax related and other considerations need to be taken into account. For example, it might make sense to pay a salary to a level which would preserve the director’s NI contribution record and would protect State Pension rights (£6,032 per annum for the 18/19 tax year).
A few of the possible tax planning options to consider are listed below:
- Transfer shares to spouses to take advantage of the dividend allowance
- Set up a rental agreement with your company for claiming ‘use of home as office’ expenses
- Make pension contributions from the company
- Extract money as interest income from the company
But tax calculations involving savings income are now very complicated. Even HMRC can't do the calculation properly in some instances and requires tax payers to files their returns on paper in those cases. Trying to bring tax to the very minimum might not actually be practical. But it's important to understand all the available options and their consequences, even if one decides to no use all of them.
We will normally base payroll for clients on these figures, but clients are, of course, more than welcome to instruct as at higher or lower levels, eg some directors prefer a higher salary level, eg £24,000 or £36,000 as they are more comfortable with this ethically.
Dividend levels and administration
So long as there is adequate tax reserve in the company, dividends can be as high and as frequent as you like – however best practice is to limit them to monthly or quarterly, and not to treat them as quasi salary.
If you are a Higher Rate tax payer there is often no merit in drawing dividends from your company just to hold the cash personally – you can defer the Higher Rate tax by leaving the money in the company undrawn. In a future year it may be possible to withdraw it more tax efficiently if you were out of contract, taking some time off, or by using a capital payment on closure; the trade off on “piggy banking” is risk, both trade risks, eg a bad debt or claim from a customer, or other risks like a IR35 challenge or other tax dispute where reserves are at risk – for this reason some people prefer to maximise their dividends to protect their profits.
Some of our clients like to restrict their drawings to the starting level of the Higher Rate tax bracket each year. For 2018/19 with a £12,000 salary, a £34,350 dividend can be drawn in basic rate. The calculation is PA £11,850 plus Basic Rate band £34,500 = £46,350 less salary £12,000. On a £34,350 dividend there will be £2,426 of Dividend Tax due.
A few points on dividends:
- Its good practice to minute dividends and prepare vouchers, however in practice a bank payment from company to shareholders counts as a interim dividend.
- Dividends can only be paid from profits – and you should make sure the company has sufficient profits before paying one. In practice, for a small business without trade creditors or debtors, cash is a good proxy for profit in most cases.
- Dividends must be split according to shareholding percentages, and its good practice to make separate payments to each shareholder, even if they are husband and wife. You can pay differential dividends using waivers or alphabet shares, but you need to take advice on these tools as they have pitfalls for the unwary.
- An interim dividend is approved by the directors, whereas a final dividend is approved by the shareholders with the annual accounts. In practice, most dividends will be interim ones paid in year at the directors behest. The main point to note though is that if a dividend is accrued in the year end accounts but not paid, then normally its considered as approved on the date the accounts were approved, which can shift it into a later tax year unexpectedly.
- Think about the impact on benefits, eg the High Income Child Benefit Charge
Income Shifting
Dividends are paid to shareholders in proportion to their shareholdings. There are useful tax savings available by bringing in another family member, normally spouse or partner, if they have unused allowances.
However in these situations considerations need to be given to the “Income shifting” rules – these are currently on the back burner but this cannot be relied on long term.
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