Author: Sharon Wright
A popular profit extraction strategy for personal and family companies is to extract a small salary, taking further profits as dividends. Where this strategy is pursued, at what level should salary be set?
Taking a small salary each tax year is tax efficient because it is a tax-deductible expense in your company. However, once salary exceeds certain thresholds, National Insurance (NI) becomes payable which makes it less efficient than taking dividends. Here are a few pointers on how much to pay yourself.
National Insurance Credit
Taking a salary of at least £6,396 in 2022/23 will mean you qualify for a credit for the year for State Pension and contributory benefits purposes. At this level no NI will be payable although you still qualify for the credit.
The optimal salary level for 2022/23 depends on whether the employment allowance is available or whether the employee is under the age of 21. In the absence of these, the optimal salary for 2022/23 is equal to the secondary threshold of £9,100 a year or £758 per month. At this level, no Employee or Employer NI is due, though it still counts as a qualifying year for State Pension purposes.
If you are a director, you could opt for a slightly higher salary of £11,908 or £992 per month. In this case a small amount of Employer NI will be payable, but this is offset by a corporation tax saving. Beyond this level, it is better to take dividends than pay a higher salary as the combined NI cost (28.3%) is higher than the corporation tax relief on salary payments.
If you can claim the employment allowance, you will get relief for the first £5,000 of Employer NI due in the tax year. The allowance cannot be claimed by sole director companies (where only one director is paid a salary), or where most of the work carried out is for Public Sector clients. Where the employment allowance is available, or if the employee is under 21, it is tax-efficient to pay the higher salary of £11,908.
Incorporated your company after 5 April 2022?
If you incorporated your company during the tax year, you only qualify for a proportion of the threshold allowances and therefore the salary you should pay yourself in the first year of trading will be less than the levels indicated above. If this applies to you, please contact our Payroll Team to check what your allowance will be.
Once the optimal salary has been taken, dividends should be paid to utilise the dividend allowance. If further profits are to be extracted there is likely to be tax to pay, but the combined tax and NI cost on taking further salary, is more than the corporation tax and personal tax on dividends, making dividends the preferred option.
Dividends can only be paid if the company has sufficient retained profits available. Retained profits (reserves) are not necessarily the same as the bank balance.
Not tax deductible
Unlike salary payments, dividends are not tax-deductible and are paid out of profits after corporation tax (at 19%) has been paid.
Dividends benefit from their own allowance, which remains at £2,000 for 2022/23, and applies to all individuals regardless of the rate at which they pay tax. The allowance applies to dividends received from ALL sources, not just from your company, but means you can receive up to this amount tax free.
Dividend tax rates
After the dividend allowance has been used, dividends are taxed at lower rates than salary payments (8.75%, 33.75% and 39.35% rather than 20%, 40% and 45%). The rate applicable depends on your total income in the tax year.
Utilise the basic rate band
Dividend income that falls into the basic rate band of £50,270 is taxed at only 8.75%. It is worth utilising your basic rate band each tax year where possible, to avoid paying tax at higher rates in subsequent years.
Where possible, we recommend that dividends are paid no more frequently than quarterly, and on an ad hoc basis, to minimise any challenge from HMRC that they are more akin to salary.
Paying the tax on dividend income
The tax on dividends is collected via an entry on your self-assessment tax return and will be due on 31 January following the tax year in which paid. Note that you may also be required to make payments on account for the current tax year. If you would like Competex to prepare this return for you, please get in touch with us and we would be happy to help. Under this service we can also assist you with tax codes issued by HMRC and the correct calculation of payments on account.
Income that is subject to the IR35 rules must be paid to the fee-earner as salary or pension contribution. Only income that is not subject to the IR35 rules can be used to pay salaries to other individuals or to pay dividends to the shareholders.
Paying other people
You can pay salary to any individual who does work for your company (including for instance your spouse and children over 16), provided you are able to illustrate to HMRC that you are paying a fair wage for the job done.
Note that paying an employee who is not a director, will give rise to pension auto-enrolment duties if the salary exceeds £833 per month.
If you have a spouse or civil partner who is in a lower income bracket than you, there may be a tax advantage in making that person a shareholder, to maximise the benefit of paying dividends. HMRC has tried to legislate against such strategies, which it refers to as ‘income shifting’, but has so far failed to do so. In the absence of any legislation to the contrary it is legitimate to distribute income in this way.
One of the great benefits of working through a company is the flexibility it gives you when deciding how much to pay yourself. The basic rate band for 2022/23 is £50,270 and therefore you may wish to contain your total income within this level to avoid paying tax at higher rates. Another consideration is if you are claiming child benefit and your total income goes above £50,000 you will start to lose it.
Once your total income exceeds £100,000, you start to lose your personal allowance (although charitable donations and pension contributions paid by you personally will reduce this level). This means that the effective tax rate on income that falls into the band between £100,000 and £125,140 can be up to 60%, so containing it below £100,000 can save you a significant amount of tax.
You may need to maintain a certain level of salary to justify your current mortgage or to secure future borrowing. Mortgage lending is based on past and present salary levels, and not every lender will accept that dividends have been received instead of salary; some lenders will only accept the figure on the P60 (certificate of pay, income tax and national insurance contributions).
Paying dividends instead of salary could restrict the amount of personal pension contributions that you are allowed to make, and we recommend that you consult a financial adviser who can assist you in devising a remuneration strategy. Alternatively, the company can pay pension contributions on your behalf, and this can be very tax efficient as it reduces the corporation tax liability. There is no restriction based on salary if the company makes the contribution. Competex are not authorised to give advice on pensions, but we can put you in touch with a financial adviser if you do not have one.
We hope this gives you a broad outline of some of the considerations to be made when deciding how much to pay yourself. If you need any further assistance, please get in touch with us.