The following article is an excerpt taken from the new guide '101 Business Tax Tips' 2021/22 edition.
To learn more about this 200+ page guide and benefit from 100 more tax saving tips go here.
One of the perceived major benefits of incorporation is the ability to extract profits by way of dividends. The main advantage is the National Insurance saving, as no NICs are payable on dividends, whereas a salary payment would attract employee NICs of 12% or 2% and employer NICs of 13.8% (2021/22 figures) once the salary exceeds the primary and secondary thresholds.
In determining the optimal salary level for 2021/22, it is necessary to take account of the availability of the NIC employment allowance (for which see Tips 71 and 72).
All taxpayers receive a dividend ‘allowance’, regardless of their marginal rate of tax. This dividend allowance is set at £2,000 for 2021/22. However, this is not an ‘allowance’ as such, rather a zero-rate band which taxes the first £2,000 of taxable dividend income at a rate of 0%. Thereafter, dividends (which are treated as the top slice of taxable income) are taxed at 7.5% to the extent that they fall within the basic rate band, 32.5% to the extent that they fall with the higher rate band, and 38.1% to the extent that they fall within the additional rate band.
A payment of salary will attract tax at the taxpayer’s marginal rate of income tax (20%, 40% or 45% (or, for Scottish taxpayers, at the relevant Scottish rate)). Salary payments are deductible in calculating profit for corporation tax purposes, unlike dividends which must be paid out of after-tax profits. Further, a dividend can only be paid if there are sufficient retained profits. In addition, various company law requirements must be met.
It is not simply a case that dividends are always best, although in many cases, taking dividends will result in less tax and National Insurance than taking a salary payment.
However, the best result will depend on the circumstances, as the decision whether to take salary or dividends will depend on the interaction of various factors – respective rates of income tax, corporation tax and National Insurance contributions, any other income that the taxpayer has and whether the company has sufficient retained profits.
To decide whether to extract profits by way of a dividend or a salary, crunch the numbers first. (The rates applying for 2021/22 and the financial year 2021 are used in the example.)
Remuneration or dividend: Example
Paul is the director of a small company. He has profits of £20,000 (before corporation tax) and wants to know whether to extract them by way of a salary or a dividend. It is assumed that he has already received a small salary equal to his personal allowance.
He has a small number of employees and has utilised the NIC employment allowance in respect of employer’s NIC payable in respect of earnings paid to his employees.
Less Employer’s NIC (£2,425)
Available to pay as salary £17,575
Less Income Tax @ 20% (£3,515)
Less NIC @ 12% (£2,109)
Retained by shareholder £11,951
There is no corporation tax to pay as taxable profits are reduced to nil after deducting salary of £17,575 and employer NIC of £2,425.
Less Corporation Tax @ 19% (£3,800)
Distributed as a dividend £16,200
Income Tax (£1,065)
Retained by shareholder £15,135
The whole dividend falls within the basic rate band (£37,700 for 2021/22). The first £2,000 of the dividend is taxed at 0% and the remaining £14,200 is taxed at 7.5%. The total tax payable on the dividend is therefore £1,065 ((£2,000 @ 0%) + (£14,200 @ 7.5%)).
In this situation, Paul is better off by paying a dividend as he is able to retain £15,135 of the profits, as compared to retaining only £11,951 if they are extracted by way of a salary payment.
For more tax saving tips for business owners and entrepreneurs, refer to our guide: '101 Business Tax Tips'.