Salary vs dividend: Extracting income from your company

If you are a director and a shareholder of a limited company, you may want to consider paying yourself a combination of salary and dividend payments.

Here we take a look at the most tax efficient options.

From 6 April 2023

England, Wales & Northern Ireland (NI):

• The personal allowance remains at £12,570.
• The dividend allowance decreases from £2,000 to £1,000.
• The basic rate limit remains at £37,700 (higher rate threshold £50,270, including the personal allowance).
• The additional rate threshold decreases to £125,140, from £150,000.
• The Class 1 National Insurance Contribution (NIC) primary threshold increases to £12,570.
• The Class 1 NIC lower earnings limit remains at £6,396.
• The NIC upper earnings limit remains at £50,270 per year.
• The employers’ NIC secondary threshold is £9,100.
• The employers’ NIC allowance remains at £5,000.

Class 1 NICs rates remain as decreased in November 2022:

• Employee main rate: 12%.
• Employee additional rate: 2%.
• Employers’ rate: 13.8%.

Dividend tax rates remain as for 2022-23:

• Basic rate: 8.75%.
• Higher rate: 33.75%.
• Additional rate: 39.35%.

Effective 6 April 2023, the dividend allowance has been reduced from £2,000 to £1,000.

Below, we provide several examples illustrating how a limited company director can optimise their tax efficiency by setting their salary at various personal allowance and national insurance thresholds and supplementing their income with dividends.

Higher-rate taxpayers

For individuals in the higher-rate tax bracket.

Scenario A. A company has generated profits amounting to £75,000. Consequently, the company is subject to the main rate of Corporation Tax with marginal relief. The director must now decide whether to distribute these profits as a salary or dividends.

Here, we assume that the recipient taxpayer falls into the higher-rate tax bracket and possesses other income sources that enable them to utilise their personal allowances (assuming they have not been fully tapered to zero) and the basic rate tax band.

The objective is to determine the overall tax rate that will be incurred if the company distributes its profits solely as a salary or dividends.

Ignoring the Employer’s (ER’s) NIC allowance which is no longer available for single director/employee companies.

Tax rate Distributes as Salary Dividend £ £ Profit 75,000 75,000 Salary 67,009 ER’s NIC 13.8% 7,991 Profit charged to tax nil 75,000 Corporation Tax 25% less marginal relief 16,125 Dividend 58,875 Dividend allowance -1,000 PAYE 40% (42% Scotland) 26,803 EE’s NIC 12% & 2% 4,858 Income Tax 8.75%/ 33.75% 19,533 Total tax and NIC 39,653 35,658 Effective tax rate 52.87% 47.54% Net Cash After Taxes 27,356   39,342

Basic-rate taxpayers

A company is faced with a decision regarding the distribution of its £35,000 profits, contemplating whether to allocate them as a salary or dividend.

Scenario B. We assume the taxpayer has no additional income and their personal allowance, as well as the basic rate tax band, are fully accessible.

If the company was to distribute its profits entirely as a salary or dividends, without considering the ER’s NIC allowance, the following tax rates would apply:

Tax rate Distributes as Salary Dividend £ £ Profit 35,000 35,000 Salary 31,859 ER’s NIC 13.8% 3,141 Profit charged to tax nil 35,000 Corporation Tax 19% 6,650 Dividend 28,350 Dividend allowance -1,000 PAYE 20% (19%, 20%, 3,858 EE’s NIC 21% Scotland) 2,314 Income Tax 8.75% 1,293 Total tax and NIC 9,313 7,943 Effective tax rate 26.61% 22.70% Net Cash After Taxes 22,547   27,057

Mix of dividends and salary for basic-rate taxpayers

To maintain basic-rate taxpayer status, directors can opt for the minimum salary necessary to retain their benefits, dependent on National Insurance Contributions (NIC). This minimum salary amount is £123 per week or £6,396 per year. The remaining earnings are then received as dividends.

The effective tax rate in this scenario is:

Tax rate Distributes as Salary Dividend Total £ £ £ Profit 35,000 Salary 6,396 ER’s NIC 13.8% 0 Profit charged to tax nil 28,604 Corporation Tax 19% 5,435 Dividend 23,169 Dividend allowance -1,000 PAYE 20% (19%, 20%, nil EE’s NIC 21% Scotland) nil Income Tax 8.75% 1,400 Total tax and NIC 6,834 Effective tax rate 19.53% Net Cash After Taxes £28,165.66

Similarly, a director can opt to structure their pay package to take the highest salary possible before NIC, while still remaining a basic tax-rate payer.

The effective tax rate in this scenario is:

Tax rate Distributes as Salary Dividend Total £ £ £ Profit 35,000 Salary 9,100 ER’s NIC 13.8% 0 Profit charged to tax nil 25,900 Corporation Tax 19% 4,921 Dividend 20,979 Dividend allowance -1,000 PAYE 20% (19%, 20%, nil EE’s NIC 21% Scotland) nil Income Tax 8.75% 1,445 Total tax and NIC 6,366 Effective tax rate 18.19% Net Cash After Taxes £28,634.46

By structuring your pay package strategically, directors can ensure that they maintain their status as basic-rate taxpayers. This involves receiving a salary equivalent to the personal allowance and the remaining amount in dividends.

The effective tax rate in this scenario is:

Tax rate Distributes as Salary Dividend Total £ £ £ Profit 35,000 Salary 12,570 ER’s NIC 13.8% 479 Profit charged to tax nil 21,951 Corporation Tax 19% 4,171 Dividend 17,780 Dividend allowance -1,000 PAYE 20% (19%, 20%, nil EE’s NIC 21% Scotland) nil Income Tax 8.75% 1,468 Total tax and NIC 6,118 Effective tax rate 17.48% Net Cash After Taxes £28,882.14

Is there an ideal salary-dividend mix?

The short answer is no. It varies based on your salary needs, income withdrawal, and potential income sharing with spouse/ civil partner or family members. If the director has no other earnings, a small salary is recommended. Just make sure it’s above the NIC lower earnings limit to maintain eligibility for state pension and other entitlements, but remain below the NIC secondary threshold to avoid liability.

Benefits of employing your spouse and children

Family members can be employed if they meet the National Minimum/Living Wage and the minimum working age requirements. They must actually work in the business to receive a salary.

Having salaried staff allows the company to claim the Employment Allowance for NIC.

If benefits in kind (e.g. health insurance) are given to non-working family members this will be taxed on the working family members instead or the director.

However, excessive wages or Benefits in Kind may be challenged by HMRC. Wages should align with what would be paid to an unrelated person with similar qualifications and duties.

Income splitting

Spouses/ Civil partners have the option to divide their income-generating assets in a tax-efficient manner, such as shares in a personal company. This can be done to take advantage of any unused tax allowances or to optimise the utilisation of a lower-rate tax band without any immediate Capital Gains Tax implications.

There is also the option to re-designate shares into different classes so different amounts of dividends can be declared to each spouse/civil partner.

What to watch out for

• A company is only permitted to declare a dividend if it has enough distributable reserves. Learn more about how a company pays dividends.
• Reserves not eligible for distribution, include capital reserves or the share premium account and any dividend declared would be deemed ‘unlawful’. The same applies to dividends paid when the company has a negative balance sheet.
• Any unlawfully distributed dividend must be repaid to the company.

For further information on salary and dividends and how you can achieve the correct split, contact Lynn Lin at llin@geraldedelman.com.