If you’re an owner-manager of a business, one of the key considerations is how can you pay yourself in the most tax-efficient way?
For those who have moved to a limited company structure, the two main options are salaries and dividends. Both have their pros and cons. Choosing the right option for your situation could make a big difference to the financial health of your business and its owners. And we’ve laid out the key points to note below.
UNDERSTANDING SALARY & DIVIDENDS
Salaries are the fixed amounts paid to employees on a regular basis, which are subject to income tax and national insurance contributions (NICs). Dividends, on the other hand, are payments made to shareholders out of the company’s profits after tax. So, they’re subject to income tax, but not NICs.
The right mix of the two will depend on your target income, the amount of cash generated in your business, and the tax planning strategy. This is why it’s essential to review your income in line with the latest changes in legislation, including:
- Corporation Tax increased from 19% to 25% from 1 April 2023. The 19% rate will still apply if the company’s profits are £50,000 or less, but more tax will be paid on profits above this level. Companies with annual profits of £250,000 or more will pay the full 25% rate, while between the two rates, a system of marginal relief will apply.
- Dividend Allowance will drop from £2,000 to £1,000 from 6 April 2023.
- The threshold for the highest rate of income tax (45%) is reduced from £150,000 to £125,140 per annum from 6 April 2023.
To understand the detail of these changes, we ran some sample figures so you can start planning in an informed way.
HOW TO BALANCE SALARY & DIVIDENDS
The short answer for business owners is that for basic rate taxpayers, paying dividends is always the better option, where the company is paying the small rate of corporation tax of 19%. This is because dividends do not attract NICs and offer tax advantages for lower rate taxpayers.
However, for higher rate and additional rate taxpayers, paying bonuses rather than dividends could be more beneficial, especially if the company will pay higher rates of CT from April 2023. The company can obtain a full deduction for the bonus, along with the employers’ NIC. This may provide additional tax relief and cash flow advantages.
Additionally, companies that fall into the marginal rates of CT may benefit from replacing dividends with bonuses as relief will be available at a higher effective rate. For basic rate taxpayers the differential between bonus and dividend is small (around1%), but the difference can be as much as 5% for those paying higher or additional rates of tax.
The effective rate of tax on profits extracted for these companies is 26.5%.
- Profits of £50,000 – taxed at 19% = £9,500
- Profits of £60,000 – taxed at marginal rates = £12,150
The difference in this case is £2,650, meaning the effective rate on an additional £10,000 is 26.5%. These are illustrative figures, and they may vary slightly by case and depending on NIC relief. However, the clear picture is that with new rates, dividends are not always the strongest tool for profit extraction.
HOW TO APPROACH BONUSES
While dividends will be the most advantageous choice for most small business owners, bonuses can be a valuable tool for targeted tax management in certain cases.
- Paying bonuses could enable companies that are eligible for Research & Development tax credits to receive a higher refund of CT. This is because the bonus is considered pre-tax expenditure, as opposed to post-tax dividends.
- Replacing dividends with bonuses may provide cash flow advantages by reducing payments on account via self-assessment. However, this assumes that tax codes and applied rates under PAYE to bonuses are correct.
- Bonuses increase the capacity to contribute to pensions as these would be treated as net relevant earnings, unlike dividends. This means that paying a bonus may increase the amount that can be contributed to a pension scheme and may provide additional tax relief.
- Paying NIC on bonuses may increase entitlements to benefits, such as jobseeker’s allowance and statutory sick pay.
While bonuses shouldn’t be considered a replacement for dividends, a managed strategy can include both to maximise personal and business benefits.
NEED A HELPING HAND?
There’s no one-size-fits-all approach to paying yourself as an owner-manager of a business. There are lots of variables to consider, such as the CT rate, the profile of your company and your shareholders.
Tax can be a major obstacle for growing businesses, especially when balancing it with your personal ambitions. From maximising reliefs to preserving wealth for the next generation, our specialist tax team look at your tax strategy holistically.
If you’ve got any questions, or you’d like some help deciding the best choice for you, our expert team would love to chat.
