When is it beneficial for a company owner or director to take a dividend rather than a salary?
Many people running businesses prefer to do so through a limited company rather than as a sole trader. One reason is that the company pays corporation tax at a rate of 19% against income tax rates of up to 45% for a sole trader. (There are different corporation tax rates for companies that make profits from oil extraction or oil rights in the UK or UK continental shelf. These are known as ‘ring fence’ companies – find out more here.)
The company can therefore shelter profits at a lower rate of tax. This is fine until the business owner wishes to extract profits from the company for his or her personal use. A payment of a salary or bonus, for example, often increases the overall amount of tax. Paying a £100 bonus from a company to its director saves perhaps £19 in corporation tax but could mean the director pays £40 or even £45 in income tax, thus increasing the overall tax bill by £21 or £26.
In addition, payment of salary can mean payment of national insurance (NI). The employer must pay NI, regardless of the age of the director, which is usually charged at 13.8% on all income above the earnings threshold, without limit.
If under statutory retirement age, the director pays NI at 12% on earnings between the earnings threshold and upper earnings limit, and at 2% above the upper earnings limit.
Salary is deductible from total profits whereas dividends are not.
It is not as simple as saying that dividends are always preferable to salary for taxpayers. There are other factors that need to be considered.
Paying dividends may not even be possible. Dividends may only be paid out of profits. This is construed widely to include profits retained from previous years, capital gains and even revaluation surpluses. But it does not include share capital or loan capital. So paying dividends may not be possible for a start-up company that has yet to earn profits.
Sometimes directors seek to get round this by keeping some business fixed assets as personal assets and charging rent. Rent can be paid regardless of profits being earned provided there is sufficient cash in the business. However, this route can create further issues regarding business property relief for inheritance tax and entrepreneurs’ relief for capital gains tax.
The director may prefer to remain an employee for non-tax reasons. For example, in a small speculative venture the director may wish to keep open the option of claiming jobseeker’s allowance should the business fail.
This can only be done by remaining an employee and being paid at least the lower earnings limit for NI purposes. This also maintains entitlement to other benefits such as state second pension and statutory maternity pay.
There are some circumstances when a taxpayer can have a marginal rate of income tax greater than 45%. This happens in three circumstances:
If the withdrawal of benefit is considered as the equivalent to tax, the rate can easily exceed 70%.
The choice of how to extract money from a company can have a significant effect on the total amount of tax paid.
If you are a director shareholder, contact us so that we can make tax-efficient recommendations that are right for you.
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