Dividends v Salary – What’s the best approach?

People who own and run their own company may take money out of their company in various ways – such as salary (or a bonus), or as dividends. This article sets out some of the benefits of dividends, the mechanics and other issues to consider.

 

Dividends are a shareholder's reward for investing in a company. Basically, the company's owners - its shareholders - have the final say on how the company is run, and the proportion of shares you own normally determines how much power you have as a shareholder, and the proportion of the overall dividend you can receive. From this perspective, there is no difference between holding shares in BT, or your own company - except for the percentage holding!

With 'small' companies, there are usually only a handful of shareholders, and the shareholders are often also directors of the company. They don't have to be both director and shareholder but it is quite normal – of course, one has to be a director (or other kind of employee) and a shareholder, in order to have the choice of salary or dividend. 

No National Insurance contributions – Dividends are investment income, and paid out of the company's accumulated profits as a return on the shareholder's investment. Unlike wages or salary, they are not earnings. In theory, no work is required in order to secure the dividend (most BT shareholders are probably not BT employees: they buy the shares, and they get dividends regardless). As they are not earnings, they do not normally suffer National Insurance contributions (NICs). Salaries generally suffer employees' NICs of 12% and employers' NICs on top of 13.8%.

No income tax (sometimes!) – Aside from the difference in NICs, the income tax on dividends is different to that for salaries. The difference is most striking when comparing dividends and salary which are within the ’basic rate band‘ - before a person's total income exceeds the 40% higher rate threshold. For salary taxed at the basic rate, 20% is taken from that income but for dividends, the effective tax rate is nil. Dividends still enjoy an advantage when comparing incomes at the higher rates of 40% and 45%, but the benefit is most marked for incomes in the basic rate. 

But no company tax relief for dividends – However, dividends can only be paid out of the profits remaining after all other expenses, including corporation tax, have been accounted for – and dividends are not tax-deductible.

Jim owns his own company. He normally takes an annual salary of £12,000 and then a bonus depending on the company’s profits for the year. This year, it looks like the company will make at least an extra £30,000. He doesn’t want to dip into his brought forward profits so any amount paid out will have to be covered by this year’s profits. 

If he pays himself a bonus, he cannot draw out the full £30,000 as he has to account for employer’s NIC. But the company’s taxable profits will fall to nil. If he pays a dividend, the company will still have to pay corporation tax on the profits.

 

Jim stands to save over £6,000 by taking the money out as a dividend, instead of a bonus. 

Below are some of the key points to ensure that dividends are valid, as they can be challenged by HMRC.

Documentation – To comply with the Companies Act, dividends must be formally considered and authorised, and noted accordingly. They should be recorded in the company’s statutory records and vouchers should be issued to the shareholders.

Accounting records – the company’s accounting records should be updated to reflect the payment, whether it is in cash or by way of credit to a director’s loan account.

Sufficient profits! – If the company doesn’t have enough accumulated profits to cover the dividend, then it may be ‘illegal’ (i.e. not compliant with the Companies Act) and the shareholders may ultimately have to repay some or all of the dividend. This is something that HMRC often picks up although their understanding of the rules is sometimes overly simplistic. 

The potential dividend is not capped at profits in the current year but at total aggregate profits, less any profits previously paid out since the company was first created.

Because there are no NICs on dividends, they do not 'earn' a right to contributions-based state benefits, such as maternity pay, or the state pension. This is one of the key reasons why it is rarely advisable to take only dividends – unless (say) you have multiple employments.

Also, dividends do not count as earnings. Earnings are essential for substantial private pension contributions exceeding £3,600 in a tax year. If you want to make larger contributions - say on the run-up to retirement, it is important to weigh up the immediate tax cost/benefit against the potential long-term implications.

A healthy mix of both salary and dividend will suit most people. Assuming no other significant income, an annual salary of at least £5,668 (this tax year) will ‘earn’ NI credits for state pension – without triggering an actual NI liability if kept to a maximum £7,696. 

Of course that is also well below the current tax-free personal allowance so a modest salary can be paid – tax-deductible in the company – without suffering any tax or national insurance. In theory, the rest can be topped up with dividends, to another £30,300 in cash, without paying any income tax. That is basically up to £38,000 tax-free – although remember that the company will have corporation tax to pay, as dividends are not tax-deductible. 

HMRC has successfully imposed an NIC charge on dividends in the past – notably in relation to a particularly adventurous large-scale tax avoidance scheme. But the ’modest salary + dividends’ approach has been around for many years, and used by a significant number of taxpayers, without challenge. 

If you want earnings in order to make more pension contributions but would rather not have to pay more tax, the company can instead make an ’employer contribution’ on your behalf. An employer contribution is not limited to your earnings in the period and will normally be tax-deductible for the company - although there is no tax relief for you personally, when the employer makes the contribution.

While the general rule is that dividends must be paid in proportion to people's respective shareholdings, it is possible for shareholders to ’waive’ their entitlement on some or all of their shareholding. However, it is not advisable to keep on waiving dividends, since it can trigger adverse consequences for income tax and even inheritance tax. 

A better long-term solution might be to have different share classes, such as ’A’ and ’B’ shares, etc., so that one dividend rate may be applied for the ’A’ shares held by one person, and a different rate for the ’B’ shares held by another (dividends do not have to be paid at the same time or with similar frequency, across different share classes). Expert advice is strongly recommended, however, and ideally, getting the shareholdings right from the outset will save problems later on.