Alan Pink considers the impact of recent changes in tax rates and rules on the ‘optimum’ salary for owner-managers.
This is just one area of business taxation covered in our popular tax report 'Tax Efficient Ways To Extract Cash From Your Company' 2022/23 edition.
At first sight, it seems like an odd question: “what is the optimum salary I can receive?” For most people, the answer is clear: “as much as my employer will pay!” But the considerations are very different for people who own and manage their own business, because people in this position have a choice as to the type of income they take.
The situation I’ll be considering here is where a business is being run by a limited company, and the same people are the directors and shareholders – an extremely common situation in UK business. The considerations are completely different if the business is unincorporated (or deemed to be so).
Because of the legal fiction that a company is a separate person from its directors and is employing them, the directors are basically treated in the same way as any other employee of the business, and earnings paid to them as salary or wages need to be put through the PAYE and National Insurance contributions (NICs) deduction mill. I once received a sarcastic school report which said: “Alan has good ideas, which he spoils by an excess of ingenuity”; and that could have been written for the current PAYE and, in particular, NICs system.
It certainly has the look of a very good idea, on first sight, that employees should ‘insure’ with the government, by way of manageable deductions from their earnings each week or month to pay for state benefits, particularly including their pension.
NICs have come a long way since that initial idea, but you would have thought it wasn’t beyond the wit of man to devise a simple and workable system; and so indeed, for the first few years, it was. But along with the growing complexity of rules and regulations, the NICs regime has turned into a bewildering array of different thresholds and rates which, very unfortunately, it’s necessary to understand in order to work out the most NICs-efficient level of earnings for you to take out of your own business.
Define your terms
Another thing I was always told at school was that I should define my terms; so let’s have a look at some of the most important ones.
Class 1 NICs are those paid by and on behalf of those who are in employment (NB there are also classes 2, 3 and 4, but these apply to the self-employed or the unemployed).
Class 1 NICs is divided into primary and secondary, with primary contributions being those deducted from the employee’s earnings, and secondary being contributions paid by the employer on top of the employee’s salary.
The lower earnings limit is the level of earnings above which the year counts for NICs purposes, and so you have that year notched up on your record in the ultimate calculation of how much state pension you’ll receive. The lower earnings limit for the tax year 2022/23 (i.e., from 6 April 2022 to 5 April 2023) is £6,396 per year, but, confusingly, this is not the level above which NICs must be made. That level is the primary threshold, and for 2022/23 this is the very much higher figure of £9,880 per year (there are corresponding weekly and monthly limits which apply depending on whether salary is paid weekly or monthly because NICs are calculated on a ‘when paid’ rather than an annual basis.).
The secondary threshold is the level above which the employer must make contributions. To ensure the maximum confusion, this is a different figure from the primary threshold, and slightly lower – £9,100 a year for 2022/23.
New tax year, new hike in rates
From 6 April 2022, the 1.25% increase in both primary and secondary NICs of 1.25% comes into effect, so planning to pay income NICs efficiently has become even more important.
For those whose earnings are broadly within the basic rate band for income tax purposes, the employee’s contribution goes up to 13.25% (from 12%), and the employer’s contribution goes up to 15.05% (from 13.8%). In other words, very nearly 30% of a person’s gross salary goes to the government in NICs; and that’s before you’ve even considered the income tax liability.
Because NICs are such a heavy impost on earned income, owner-managed business (OMB) planners tend to assume without question that it’s a good idea to minimise NICs; but it may be worth just examining this assumption. After all, surely the original concept of NICs is as a form of saving up for your retirement? Most people’s response to this would be a cynical laugh, and I have to say I have some sympathy with this reaction. The reality is not that the government saves up your contributions in some kind of ‘pot’ and pays this over to you in retirement. The government spends its NICs as it gets them, either on providing current pensions or whatever. And the so-called ‘employer’s NICs’ doesn’t seem to give rise to any entitlement to state benefits at all in itself.
A working rule
So, the working rule which most OMBs, and those advising them, adopt is to pay a small salary, typically over the lower earnings limit but below the primary threshold, which will mean that the year qualifies for the basic state pension but no NICs actually have to be paid.
To keep the figure below the employer’s contribution threshold as well, you would want to pay no more than £9,100 a year, which equates to £758 per month. Typically, this is what happens in practice, with a monthly salary being paid of an amount which for 2022/23 will therefore be between £533 and £758; and the rest of the income that the individual wants to take out of the company is typically taken as dividends.
Does the rule ‘token salary, the rest as dividends’ still apply for 2022/23? My answer to that, for a ‘typical’ entrepreneur, is a definite “yes”. I’ll spare the pages of calculations which have led to this conclusion; but using rounded figures, a basic rate taxpayer will normally be paying to the government 42% of the profits available to reward them for their efforts; whereas if they take the income as dividends, that rate is the much lower figure of 26%. It’s true that these rates assume 19% corporation tax because that is the rate that still applies in the 2022/23 tax year. But when the rates go up after April 2023, the equivalent rate is still only about 31.5% going down the dividend route, and even if you take a ‘marginal rate’ calculation, the dividend route still results in a 33% payment to HMRC overall.
Better ways of doing it
In all the above, of course, I’ve assumed that you’ve got a straightforward choice between paying salary or dividends. Not everyone is in this position. Those who own property personally, for example, that is used by the company for its business, can charge a rent, which is actually a much better way of taking income out of the company (ignoring capital gains tax considerations) than either salary or dividends because the basic problem with the modern system of taxing dividends is that the lower rates do not compensate you fully for the fact that dividends are paid out of post corporation tax income; and this position will get even worse when the corporation tax rate goes up to 25%. As ‘unearned income’, rent is not subject to NICs.
Arguably better still is the situation of the person who has a credit balance on their director’s current account or director’s loan account with the company. This person can draw out funds without any liability at all, either to tax or NICs, as a repayment of the amount the company owes them.
