Company Profit Extraction
Latest position on salary vs dividends
COMPANY OWNERS wishing to extract profits from their companies as tax efficiently as possible face an array of conflicting and ever-changing factors.
There are other methods but, in most cases, the choice facing the typical director/shareholder is salary or dividends.
In this article, I will take a detailed look at the principles involved in comparing salary and dividends and consider this vital tax planning issue for payments made during the current tax year ending on 5th April.
Salary is subject to both income tax and national insurance but usually also provides a corporation tax deduction. The tax treatment of bonuses is generally the same, although there is more flexibility over the timing of bonus payments.
Salary up to the amount of the earnings threshold (£5,715) can be paid free of any national insurance for both the employer and the employee. Provided the director/shareholder’s other income is no more than £760, it will also be free from income tax.
Since the salary usually provides corporation tax relief, this leads to an overall saving. As if that wasn’t enough, any salary in excess of £5,044 also secures state pension entitlement.
In short, a salary of at least £5,715 is generally highly beneficial in the vast majority of cases.
The next question is whether it is worth increasing the director/shareholder’s salary up to the level of the personal allowance (£6,475 for individuals aged under 65).
Salary in excess of £5,715 will attract both employee’s and employer’s national insurance, at 11% and 12.8% respectively, adding substantially to the cost. The extra salary and employer’s national insurance will, however, attract some further corporation tax relief.
For smaller companies, with profits not exceeding £300,000, the national insurance cost outweighs the corporation tax relief, so further salary beyond the £5,715 earnings threshold is not tax efficient (although there may be other reasons for paying it).
Where the company’s profits exceed £300,000, however, the value of the extra corporation tax relief on a salary of £6,475 is sufficient to make this slightly higher level of salary worthwhile.
This assumes the director/shareholder has no other taxable income apart from salary from their own company and dividends (from almost any source). If they do have such other income, the optimum solution is generally to deduct it from their personal allowance to arrive at the best level of salary to pay.
Karen’s company makes annual profits of around £400,000. Her only other source of taxable income is a modest savings account which yields interest of £100.
The optimum solution for Karen is to pay herself a salary of £6,375 (£6,475 - £100).
Once the director/shareholder’s personal allowance is exhausted, any further salary will generally produce a tax cost of at least 43.8%: made up of income tax (20%), employee’s national insurance (11%) and employer’s national insurance (12.8%).
As before, there are many reasons why it may make sense to pay a higher level of salary but, from a pure tax perspective, a salary of more than the personal allowance is generally not worthwhile (except in some special cases, such as directors over state retirement age taking a salary out of a company with profits between £300,000 and £1,500,000 and an accounting period ending before November 2011).
In most cases, the best strategy from a tax viewpoint is usually to take any further payments by way of dividends.
Where a salary of £5,715 is paid, a further sum of up to £34,344 can be extracted as a tax-free dividend (subject to any other income which the director has). This combination gives the director/shareholder the maximum total tax-free income for 2010/11: £40,059.
To put that into perspective, that is equivalent to the net take home pay received by an employee on a salary of £57,200.
A couple owning a company together can potentially ‘double up’ their tax-free income to £80,118. One person alone would need a salary of almost £129,500 to receive this much net pay!
If paying enough salary to fully utilise the director’s personal allowance, the maximum tax-free dividend is slightly less: generally £33,660.
In either case, these maximum tax-free dividends will bring the director’s total taxable income up to the higher rate tax threshold: £43,875. The reason that this differs from the actual amount of tax-free income received is the one ninth tax credit which attaches to dividends: a dividend of £9 is generally treated as if it were £10 of income with £1 of tax deducted at source (although unlike the tax deducted at source on interest income, dividend tax credits are never repayable).
If a director wishes to take further sums out of their company during the same tax year, a dividend remains the best option, although it will give rise to an income tax liability of 25%.
During 2010/11, Alex pays herself a salary of £6,475 and a dividend of £84,173 out of her company, Hello Sweetie Ltd. She has no other income.
Alex’s salary will be free of income tax but she will suffer national insurance at 11% on the amount in excess of the £5,715 earnings threshold. This amounts to £84, leaving Alex with a net £6,391.
The first £33,660 of Alex’s dividend is tax-free but she suffers income tax at 25% on the remaining £50,513 (payable on 31st January 2012 via the self-assessment system). This leaves her with a net sum of £71,545 (£84,173 - £12,628). Adding this to her net salary gives Alex total net income after tax of £77,936.
At this stage, it is worth pointing out that the director’s income tax liability is based on the amount they receive during the tax year ending on 5th April and not on the amount paid by the company during its own financial year. Hence, for example, a company could pay a dividend on 5th April 2011 and another the next day and the director/shareholder would be able to use two years’ worth of personal allowances and basic rate bands, even though both dividends came out of the same accounting period.
Returning to Alex, adding in her dividend tax credit, we see that she has taxable income of £100,000 (£6,475 + 10/9 x £84,173).
For those paying themselves a salary of £5,715, it takes a dividend of £84,857 to give them total taxable income of £100,000. Their total net income after tax would be £77,944.
Many director/shareholders will be satisfied with the net after tax income of almost £78,000 which they can receive before their gross taxable income reaches this level. For those who wish to take any more out of their company, however, we face a new problem: withdrawal of their personal allowance.
Once an individual’s gross taxable income exceeds £100,000, their personal allowance is withdrawn at the rate of £1 for every £2 of additional income. This creates an effective marginal income tax rate of 60% on most types of income. For dividends, the effective marginal rate ranges from 37.5% to 54.2%, depending on the amount and type of the individual’s other income.
Nevertheless, for those who already have income at this level and wish to extract further sums from their company, a dividend will usually continue to be the best option.
So far, we have seen that the most tax efficient payment strategy for director/shareholders is to pay a salary of either £5,715 or £6,475 (depending on the company’s profit level) and then take any further sums by way of dividend.
The position may, however, be altered where the director is planning to take enough money out of the company to take their total taxable income for the year over £100,000. Remember that taxable income includes the one ninth tax credit on dividends; for example, a dividend of £90,000 gives rise to taxable income of £100,000.
There is a band of taxable income between £100,000 and £112,950 where the director’s personal allowance is being withdrawn and where the effective marginal rate of tax on a dividend depends on the amount and type of the other income received by the director in the same tax year.
If you already have enough income to be in this tax band then a dividend remains the best option and it’s as simple as that.
But, if you’re planning ahead and have not yet taken any salary out of your company in this tax year, you can improve the position still further by re-assessing the salary level which you take. Reducing your salary may reduce the effective marginal tax rate on dividends falling into the £100,000 to £112,950 income bracket; in some cases it will reduce it enough to more than compensate for the reduction in corporation tax relief on your salary.
Where you plan to take enough money out of the company to give you total taxable income for the year of more than £112,950, the optimum strategy from a tax viewpoint alone will usually be as follows:
- Company profits not exceeding £300,000: pay no salary at all, take everything by way of dividend
- Company profits exceeding £300,000: pay a salary of £5,715, take everything else by way of dividend
In practice, taxable income of £112,950 translates into a dividend of £101,655 which will yield a net sum of £84,656 after tax; or a salary of £5,715 and a dividend of £96,512 which together will yield a net sum of £84,085 after tax. (If you’re wondering how salary can still be worthwhile, remember it attracts corporation tax relief.)
In The Middle
This leaves us with director/shareholders who wish to take a sum out of their company which will give them total taxable income of between £100,000 and £112,950.
Establishing the best solution in these cases can be a little complex and there is a wide range of potential ‘optimum’ solutions.
Where your company’s profits do not exceed £300,000, the best solution is generally found by paying yourself a salary equal to the lower of the earnings threshold (£5,715) and your remaining personal allowance after the withdrawal described above.
Working this out requires some complex algebra, although you actually only need to worry about this if the total net sum after tax which you want to take out of your company is between £78,799 and £84,656. Any less than this and you should stick with a salary of £5,715 and pay the rest as dividends; any more and you should forget the salary and take it all as a dividend.
For companies with profits in excess of £300,000, the position is even more complicated. Once again, however, there is a limited band of total net after tax income where these complications apply; in this case £77,936 to £84,300.
For those whose after tax income will fall between these limits, their salary should generally be restricted to the amount of personal allowance remaining after the withdrawal described above; although for companies with profits between £300,000 and £1,500,000 and an accounting period ending before July 2011, the director/shareholder’s salary should not generally be reduced below £5,715.
More complex algebra is required to determine the ‘optimum’ solution which may see the director receiving a salary of as little as £347 in some cases. Rather bizarrely, however, once the director’s after tax income exceeds £84,300, a salary of £5,715 usually becomes more beneficial than any lower amount.
Many director/shareholders may be able to benefit by exploiting other methods for extracting funds from their company which are sometimes available, such as by charging rent on property, interest on loans or, indeed, by taking a loan from the company. The option of getting the company to make pension contributions on your behalf is often worth exploring also.
Finally, remember that all of the above is based on tax considerations only. There are many other factors which a director/shareholder should consider when deciding what level of salary to take out of their company, including establishing sufficient ‘earnings’ to cover pension contributions, having sufficient income to support mortgage applications (some banks will not take dividends into account), and the fact that a salary of at least £5,045 secures your state pension entitlement.
In this article, my aim has been to set out the tax considerations applying when a ‘typical’ director/shareholder wishes to extract funds from their company.
The trouble is that many director/shareholders are not ‘typical’. In practice, a great many other factors may need to be taken into account when deciding on the most tax efficient strategy for withdrawing company profits.
Some of the main points to consider are:
- Other income which the director receives in the same tax year: this may alter their ‘optimum’ payment strategy
- Directors over state retirement age: no employee’s national insurance is payable on salaries
- Directors aged 65 or more: higher personal allowances may be available
- Pension contributions and gift aid payments: these extend the size of the director’s basic rate tax band
- Capital gains arising after 22nd June 2010: extracting funds from your company may increase your CGT bill
- Associated companies: the company’s marginal corporation tax rate may be altered
- Loss-making companies: salaries may not provide any corporation tax relief for many years or, conversely, may form part of a loss carried back up to three years to provide corporation tax relief at a much higher rate
- Companies with little or no distributable reserves: under Companies Act 2006, a company must produce a set of accounts to demonstrate it has enough reserves to cover each dividend it declares