Are dividends the best method of payment?
When you are running your business through a limited company, you need to structure how you will pay yourself. You may be doing all the work, but legally it is the company which invoices the customers. It is the company that pays the suppliers, settles the tax and banks the surplus. All the assets, liabilities and the profit earned belong to the company.
The big question is: what’s the best way of getting money out of the company and into your bank account?
Owner managed businesses more often than not are set up by someone who works in the business. And when the business is set up as a limited company, that person will most likely become a director. Usually the director also owns shares, so is a shareholder, or owner of the company.
Therefore, it’s not uncommon for one person to have three different legal relationships with the company (or wears ‘three hats’). Firstly, as an employee, working in the business. As a director they have a duty to, ensure the company fulfils its legal responsibilities. And, lastly, they are an owner, holding shares in the company.
Legally, how you take money out of the company and pay it into your bank account depends on these relationships.
Whose money is it anyway?
As a director of the company you can decide on the best way to pay yourself. For the most part, this is either by salary or by way of dividends. In some circumstances interest or rent can be paid to the owner-manager by the company. However, you must remember that the company is a separate legal entity and each director must respect and observe this. Even if there is only one director, owning all the shares, with no other employees, this is an important distinction. By not following the rules, it could lead to a loss of the limited liability status should things go wrong. And what’s more, it could also jeopardise the director’s own personal assets.
There are many rules governing what and how much can be paid by the company. A combination of personal tax, company tax and national insurance means that getting the balance right can be tax efficient. However, getting it wrong can be expensive!
Should I pay myself a salary?
By providing services to the company, the director is considered an employee who can be paid a salary. This is a deductible expense against the company’s profits and so reduces the company’s tax bill. Any salary paid must be reported each month to HMRC via the Real Time Processing (RTI) system. Above a certain level, tax under PAYE and national insurance will need to be deducted as for any other employee.
A company director does not need to have a contract of employment. Therefore, because there is no contract, there is not the minimum wage requirement that applies to other employees. Also, as long as it’s not excessive, considering the work the individual does for the company, the salary can be as high as you like.
Paying a salary is therefore the most straightforward way to pay yourself. It’s up to the director to decide how much the company will pay. However, there is a downside. Although the company saves tax on the salary, the gross pay is taxable income in the hands of the director. Additionally, over a certain level, National Insurance is charged on the company via Employers National Insurance. This is not only charged to the company, but to the director/employee via Employees National Insurance.
In the 2020/21 tax year, corporation tax is charged at 19% of profits. Assuming there is no other income, once an individual has exceeded their Personal Allowance of £12,500 in the tax year, they could earn up to £37,500 and be taxed at 20%. Any salary earned above this is charged at the Higher Rate of 40%. Employees National Insurance is 12% and becomes payable on earnings over £183 per week. Employers National Insurance is 13.8% and is charged on earnings over £169 per week.
So, what does this mean? In short, it means that you need to calculate the optimum salary to pay yourself. How do you save corporation tax at 19% without paying more than necessary in income tax and national insurance?
What other entitlements may be affected?
The current rules for the State Pension is that a person must complete 35 ‘qualifying years’. The basic pension entitlement is achieved if salary paid is between £120 and £183 a week. This band of earnings has the advantage of being below the threshold of having to pay Employees National Insurance. The salary should therefore be set between £6,240 and £9,500 per year for 2020/21.
Companies with employees have been entitled to an Employers Allowance of £4,000 since April 2020, which goes towards the cost of Employers National Insurance. However, if the company has only a single director who is the only employee being paid above £169 per week, the company does not qualify for this Allowance. This means that the company will have to pay Employers National Insurance at 13.8% on salary paid over £169 per week.
Extraction of profits through dividends
The directors may decide to declare dividends to shareholders when the company is profitable, provided that it has sufficient reserves. Dividends are not subject to National Insurance Contributions and are paid out of profits after corporation tax. So, although the company will pay tax at 19% before dividends can be paid out, paying dividends rather than a salary can reduce the overall amount of tax and National Insurance paid by both the company and the individual.
Dividends are taxable as income in the hands of individuals. However, currently they are taxed at a lower rate than a salary or a rental income.
Currently the first £2,000 of dividend received by an individual is at 0% tax. Dividends over this amount are taxed according to the individual’s income. This is at 7.5% (basic rate), 32.5% (higher rate) and 38.1% (upper rate).
Can my company contribute to my pension?
Paying pension contributions is tax efficient as the company saves corporation tax. Also, there is no taxable benefit or national insurance payable by the company or the director. An employer can make any level of contribution into an employee’s scheme, subject to annual and lifetime contribution limits.
Can I charge my company rent?
If the company is based at your home address, then you can charge it rent. Similarly, if the company uses any commercial property that you own privately, you can also charge rent.
The rent received, less expenses such as mortgage interest and services, must be declared by the director under self-assessment. This is done by completing the land and property pages on your tax return. As with salary, the company will save corporation tax at 19%. Whilst the rental income is taxed on the individual paying basic rate tax at 20%.
A tax advantage occurs because rental income attracts neither Employers nor Employees National Insurance. On top of this, if you receive rent, you are running a commercial property letting business. In which case, you may claim a proportion of your relevant overheads and variable costs.
An alternative treatment is for the director to reclaim expenses from his company on the same basis as any employee who is home-working. However, this generally denies any deduction for mortgage, interest, council tax or mixed-use costs.
You must also be careful not to create complications with a possible Capital Gains Tax issue. Or, indeed, a charge for business rates. For this reason, a formal agreement should exist which allows the company use of the home office between certain hours. The agreement will then allow you and your family access and use of the home office outside these hours. There should also be company minutes to record the agreement to pay rent to the director.
If the company uses a commercial property that you own, there should be a formal rental agreement in place. The rent paid by the company should be at the commercial market rate. There are currently restrictions on entrepreneurs relief if the director is charging rent. If you are in this situation, you should discuss it with a professional advisor.
Paying interest to the director
If the director provides funding to the company to provide working capital, this can be provided by a director’s loan. As with rental payments, there should be an agreement in place to pay interest for the use of the funds.
In the 2020/21 tax year there is a personal savings allowance. For basic rate tax payers it is up to £1,000 and for higher rate tax payers it is limited to £500. The company can save corporation tax on the interest. However, the nil-rate savings band would mean the income to the individual would be tax free up to these limits.
Is the owner planning to retain profits within the company?
Keeping profit in the company is a useful strategy for taxpayers wishing to avoid higher rates of tax. For example, it may be decided that they will extract profits up to the maximum to be taxed at the basic rate. Additionally, if one spouse earn over £50,000 the Government begins to
It is sensible to be aware of cash levels in the balance sheet if a company sale or retirement is planned. If cash is too high and there is a significant drop in trading, the combination of the two may affect the trading status of the company. This in turn can affect the amount of Capital Gains Tax, Inheritance Tax and Business Property Relief that will be payable.
Advisors have been successful for many years in helping owner manager businesses to reduce their overall corporate and personal tax. A popular strategy for doing this has been the combination of low salary and high dividend. However, there have been two major changes in recent years which have highlighted how changing circumstances may affect tax planning.
The first was when the Chancellor introduced tax on dividend income which came into force on 6 April 2016. A dividend allowance was introduced together with tax rates on dividend income above this allowance. This fundamentally changed the nature of dividend income, especially for taxpayers who always kept their income within the basic rate. Previously the company had paid tax on profits and the dividends carried a tax credit which effectively paid the tax on dividend income for the individual.
Although this change affected how much tax a director shareholder would pay, dividends remained a tax-efficient method of extracting company profits.
The second circumstance which has affected director shareholders has been highlighted by the Government support through the Covid-19 pandemic. Where dividends have been the main source of income, there has been no support to cover the loss of dividend income. This has meant that many directors have had to change to drawing a salary in preference to dividends. Falling income in the company, due to the pandemic, has meant that there was insufficient profit to pay out dividends.
A Very Small Business Example
In this example, assuming there was no income from other sources, no income tax would be payable by the director. They could potentially receive £20,500 if they structured their pay as follows:
|Type of income||Salary||Rent||Interest||Dividend||Total|
Important: All the examples given above are quoting tax rates and allowances for the 2020/21 tax year. These will likely change in future years. Therefore, the optimal level of salary and dividends to be paid to the director and shareholder will also change. This example and the rates referred to in this article areis for illustration purposes only and should not be construed as professional advice. You should consult an accountant or tax professional to ensure payments to you by the company are tax efficient. You should also obtain professional guidance to ensure you are adhering to tax and company law rules and regulations.
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