Optimal Salary Level
When deciding on what level of salary to pay, it is important to remember that while there are some general rules, there is no `one size fits all’. Assuming that the director’s personal allowance is available and not otherwise utilised, the optimal salary will depend on whether or not the employment allowance is available. The employment allowance is set at £4,000 for 2021/22 and, where available, will shelter employer Class 1 NICs, which would otherwise be payable up to this level. However, not all companies can benefit from the allowance and it is not available if the company is a personal company where the sole employee is also a director.
Employment allowance not available
The employment allowance is not available to a company in which the sole employee is also a director. This means that a personal company is unlikely to be able to benefit from the employment allowance. This will impact on the calculation of the optimal salary.
Having decided to pay a salary of at least £6,240 in order to secure a qualifying year for state pension purposes, the next question to consider is whether it is worthwhile to pay a higher salary. The position is complicated by the fact that the primary and secondary thresholds for National Insurance are not aligned – for 2021/22 the secondary threshold is set at £8,840 and the primary threshold at £9,568.
Assuming the personal allowance is available in full (and the director is 21 or over), between the lower earnings limit (£6,240) and the secondary (£8,840), there is no tax, employee’s or employer’s National Insurance to pay.
Thus, the maximum salary that can be paid free of tax and National Insurance if the director is aged 21 or over and the Employment Allowance is not available is one that is equal to the secondary threshold of £8.840. This is equivalent to a salary of £737 per month.
Salary payments above this level attract employer’s National Insurance at 13.8%. However, both salary payments and the associated employer’s National Insurance are deductible for corporation tax purposes, generating a corporation tax saving of 19%.
Where a salary of between £8.840 and £9,568 is paid, employer’s National Insurance will be due, but not tax or employee’s National Insurance.
The employer’s National Insurance (at 13.8%) is outweighed by the corporation tax saving. Paying an additional salary of £728 for the year over the maximum tax and NIC-free salary of £8.840 to bring the salary up to the level of the primary threshold of £9,568 will trigger an employer’s Class 1 National Insurance liability of £100.46 (£728 @ 13.8%).
However, the additional salary of £728 and associated employer’s National Insurance of £100.46 (totalling £828.46) will generate a corporation tax saving of £157.41 (19% of £828.46). As the corporation tax reduction outweighs the secondary Class 1 National Insurance payable, it is tax efficient to pay a salary equal to the primary threshold of £9,568.
Paying a salary in excess of £9,568 will trigger a liability to both employee’s National Insurance of 12% and employer’s National Insurance of 13.8%. However, no tax is payable until the salary level reaches the personal allowance of £12,570. Is it worthwhile paying an additional £3,002 in salary to bring the salary up to the level of the personal allowance?
The additional salary of £3,002 will attract both employer’s and employee’s National Insurance contributions. Employer’s contributions will be £414.28 (£3,002 @ 13.8%) and employee’s contributions will be £360.24 (£3,002 @ 12%) – a total of £774,52.
The additional salary and associated employer’s National Insurance are deductible for corporation tax purposes, reducing the corporation tax bill by £649.09 (19% of £3,416.28). As the cost of the employer’s and employee’s National Insurance at £774.52 outweighs the corporation tax saving of £649.09, paying the additional salary is not worthwhile.
The optimal salary for 2021/22 where the personal allowance is available, the director is over the age of 21 and the National Insurance employment allowance is not available is one equal to the primary threshold of £9,568. If paid monthly, this is equivalent to £797 per month.
Remember, directors have an annual earnings period for NIC purposes. This is useful, as even if the salary in some months is more than £792, as long as the annual salary is not more than £9,568 no employee’s National Insurance will be payable.
This allows flexibility to pay different amounts at different times. However, if salary in any month is to exceed £797, the director would want to use an annual earnings period from the outset rather than calculate the liability for each pay period with a recalculation on an annual basis when the last payment in the tax year is made.
It should be noted that as the primary and secondary NIC thresholds are not aligned for 2021/22, employer’s National Insurance is payable on a salary between £8.840 and £9,568.
Employment allowance available
The availability of the employment allowance impacts on the calculation of the optimal salary level and makes it tax and NIC-efficient to take a higher salary, as long as the available employment allowance is sufficient to shelter the employer NIC liability that would otherwise arise.
The employment allowance is set at £4,000 for 2021/22 and is available to (most) companies with more than one employee and to single employee companies where that employee is not also a director, where their Class 1 National Insurance bill for 2020/21 was less than £100,000.
Where the employment allowance is available to set against the employer’s NIC on the director’s salary, there is no National Insurance to pay until the primary threshold, set at £9,568 for 2021/22 is reached.
Thus, in this situation, the maximum salary that can be paid tax and NIC-free is one equal to the primary threshold of £9,568.
Where the employment allowance is available it can be beneficial to pay a salary above the primary threshold. If the personal allowance is not used up elsewhere (for example, by rental or investment income), for 2021/22 it can be advantageous to pay a salary equal to the personal allowance of £12,570.
Although the director will pay NIC to the extent that the salary exceeds the primary threshold of £9,568, there is no employer’s NIC to pay as the employer’s NIC that would be payable at a salary of this level is offset by the employment allowance.
Although the director will have to pay some employee’s NIC at this level, the employee’s NIC paid by the director is more than offset by the Corporation Tax deduction available for the additional salary paid in excess of the primary threshold.
For 2021/22, a director will pay employee’s NIC of £360.24 on a salary of £12,570 (12% (£12,570 - £9,568)) compared to nil on a salary equal to the primary threshold of £9,568.
However, the additional salary paid in excess of the primary threshold of £3,002 (£12,570 - £9,568) is deductible for Corporation Tax, generating a further Corporation Tax deduction of £570.38 (£3,002 @ 19%) (financial year 2021 rate).
The effect of the employment allowance means that it is possible to save £210.14 (£570.38 - £360.24) by paying a salary equal to the 2021/22 personal allowance of £12,570, rather than paying a salary equal to the 2021/22 primary threshold of £9,568.
The saving of £210.14 is 7% (£12,570 - £9,568), 7% being the difference between the Corporation Tax rate of 19% and the employee NIC rate of 12%.
If the director is entitled to a personal allowance of more than £12,579, for example, because they have received the marriage allowance, worth £1,260 for 2021/22, the optimal salary where the employment allowance is available will be equal to that higher salary (£13,830 for 2021/22).
Director is under the age of 21
Where the director is under the age of 21, the calculation of the optimal salary is the same calculation as that used above where the employment allowance is available applies.
In this case, no employer’s National Insurance will be due on a salary equal to the personal allowance of £12,570 for 2021/22 as no secondary contributions are payable on the earnings of an employee/director under the age of 21 until earnings exceed the upper secondary threshold for U21s, set at £967 per week for 2021/22 (£4,189 per month, £50,270 per year).
The same is true in relation to apprentices under 25. Where this is the case, this will be the optimal salary level, rather than one equal to the primary threshold of £9,568 for 2021/22.
Paying a salary in excess of the personal allowance
Is it worth paying a salary higher than one equal to the personal allowance of £12,570 for 2019/20? The answer will depend on the amount of profits to be extracted, whether the employment allowance is available, whether the director is entitled to other allowances, such as the blind person’s allowance or the married couple’s allowance, and the director’s marginal rate of tax. There is no substitute for doing the sums.
Generally, however, where the salary exceeds the personal allowance, any further salary will suffer tax at the basic rate (at 20%) and employee’s National Insurance (at 12%), even if no employer’s National Insurance is due.
The combined tax and employee National Insurance hit at 32% is more than the associated Corporation Tax saving (at 19%), so once this level is reached, other extraction methods may be preferable to take advantage of allowances and lower tax rates.
A point to bear in mind is that if the director is a basic rate taxpayer and in receipt of the marriage allowance (£1,260 for 2021/22) such that their personal allowance for 2021/22 is increased to £13,830 and the employment allowance is available, it will be beneficial paying a salary equal to the higher personal allowance where the employment allowance is available to shelter the associated employer’s NIC, or the director is under the age of 21.
However, where a spouse or civil partner is unable to fully utilise their personal allowance, a better option would be to employ them within the company if this a practical option, to enable all of their personal rather than only 10% of it to be used to shelter profits extracted from the company.
However, as always, while the maths may work from a tax perspective, there may be non-tax reasons why the director may not want to go down this route and, as always, the tax tail should not wag the proverbial dog.