Directors can pay themselves from their limited companies either in the form of dividends or salary but following changes in 2016/17 to the treatment of dividends, they now need to give a bit more upfront consideration and attention to which they pick so that they are able to remunerate themselves within the most tax efficient manner.
Paying themselves in the most tax efficient way will require directors to apply a strategy combining both dividends and salary.
How Salary and Dividends Are Taxed
In the current tax year (2017/18) the first £11,500 of income is tax free due to this being the current personal allowance threshold.
Assuming that salary is your only form of income, salary above £11,500 will be taxed at 20%, with this increasing to 40% once salary reaches the higher band of £45,000. This increases to the top bracket of 45% when your overall salary is over £150,000.
The dividend allowance, first introduced in April 2016, means that the first £5,000 received by an individual are tax-free.
Once this value of dividends is exceeded, and if you have unused personal allowance left (i.e. up to £11,500), this element will also be tax-free.
Thereafter, dividends in the basic rate tax band (up to £45,000) are taxed at 7.5%, with this increasing to 32.5% for higher rate taxpayers (over £45,000), and 38.1% for additional rate taxpayers (over £150,000).
By fully utilising the personal allowance and dividend allowance in the current tax year, directors can receive tax-free income of £16,500 (£11,500 salary and £5,000 dividends).
Utilise the Tax Efficient Dividend And Salary Structure
It is common for directors of limited companies to choose to limit their total income to the higher rate threshold (currently £45,000) so that they are not taxed at more than 20%.
Whilst everyone’s personal circumstances and living costs are different, a common strategy is to be remunerated up to this level through both dividends, and a minimal salary which enables the recipient to continue to contribute to qualify for a future state pension without having to pay NICs or income tax.
This tax-efficient salary is also a qualifying business expense, which means that the director’s company will be able to reduce their corporation tax bill by 19% of the gross salary.
Up until the tax year, 16/17 directors of limited companies were able to utilise the Employment Allowance (first introduced in April 2014), to reduce employer NICs. Whilst it was previously a common strategy for single director employee companies to increase their salary up to the allowance limit, this benefit is now no longer available to companies where the single director is the only person on the payroll.
It may still be possible to utilise the Employment Allowance (£3,000 in 2017/18) for companies which have a husband and wife on a two-person payroll. However, guidance from HMRC is relatively ambiguous so directors are recommended to err on the side of caution.
The Optimum Level of Salary and Dividend To Pay And Still Remain A Basic Taxpayer
The below working illustrate the optimums level of salary and dividends directors should pay themselves in order to remain a basic taxpayer, and still benefit from future state pension payouts.
The example assumes that the recipient has no other forms of income and that they do not qualify for the Employment Allowance.
In this calculation, the recipient pays themselves a salary of £8,164 which allows them to qualify for future pension benefits but not attract NICs or income tax. The first £8,336 of dividends are not taxed due to using up the balance the £11,500 personal allowance (£3,336) alongside the next £5,000 utilising the tax-free dividend allowance.
The remaining £28,500 of dividends are taxed at 7.5% and take the director up to the basic rate taxpayer threshold of £45,000.
As the salary is a business expense, the company also benefits from £1551 of saved corporation tax.
Whilst in certain circumstances directors may be able to also utilise the Employment Allowance, this will result in an overall tax saving for the company (£2,185, instead of the £2,138 cited above) but with the individual receiving less net remuneration personally (£401).
Assistance With Salaries and Dividends
If you have a small business and would like to ensure that you are extracting money in the most tax-efficient way then talk to us. We are chartered accountants and tax advisors with offices in the Midlands and in London. Our local offices provide support to local businesses with sound tax and accounting advice and good local economic knowledge, talk to our teams in Northampton, Daventry, Rugby and London.