Jennifer Adams considers the most tax-effective methods for a director to withdraw profits from an owner-managed company.
There are various methods by which directors can withdraw profits, but as a director is usually also a shareholder the two main methods are via a salary (and/or bonus) or dividend, or a combination. The aim is to find the method or combination that results in the minimal amount of tax payable by both the director-shareholder and the company depending on individual circumstances.
The preferable method can only be determined by comparing the net amount received after all taxes (including corporation tax) and National Insurance contributions (NIC) charges (if any) have been calculated. Several factors may be relevant, not least whether the director has other income against which the personal allowance can be offset. Other factors include the availability of the employment allowance (EA) to the company, whether the director is still repaying student loans, the availability of the dividend allowance, whether the director wishes to make pension payments and whether the director has sufficient years ‘clocked up’ towards their state pension.
Salaries and bonuses are classed as an allowable business expense for corporation tax purposes, but in comparison dividends are not tax-deductible, being paid out of profits on which corporation tax (currently at 19%) has already been paid. If personal allowances have already been allocated elsewhere or used against salary already taken, it is generally more tax-efficient to pay via dividends.
However, it is important to note that to fund any dividend payments, a company must have sufficient 'distributable reserves' remaining after the company has paid its corporation tax. Should the profit be insufficient to enable payment and a distribution is made from capital instead, the director-shareholder may be liable to repay the cash. Therefore, the company needs to have set aside sufficient profits to cover the amount of dividend as at the date of payment. In comparison, such 'reserves' are not required to pay salary or bonuses.
'Optimum' amount to pay
Historically, many business owner-managers have been able to achieve tax efficiencies by taking a relatively small salary supplemented by dividends. However, successive budgets have reduced the dividend advantage; so much so that for director-shareholders in certain income brackets, there is little difference in net take-home pay between salary payments and dividend income.
Assuming there is no other income against which the personal allowance can be allocated, the 'optimal' salary amount depends on whether the EA is available. Following the Spring Statement, the employee NICs primary threshold (NICs PT) was increased as from 6 July 2022 to match the personal allowance amount of £12,570 such that the employee NICs PT is £11,908 for the tax year 2022/23. Therefore, if the EA is not available, the optimum salary for 2022/23 is £11,908; if the EA is available, the optimum salary is £12,570.
Once the optimum salary has been paid, dividends can be paid to use up the dividend allowance (£2,000 for 2022/23). If further profits are to be extracted, there will be tax to pay but the combined tax and NICs hit for dividends is less than for salary payments, making them the preferred option. Once the allowance has been used, dividends are taxed at 8.75%, 33.75% and 39.35% rather than 20%, 40% and 45% as chargeable against a salary or bonus. Therefore, when income exceeds £13,908, the dividend route is more advisable.
Practical tip
Planning is key to any profit extraction policy, not least in the next tax year; after 1 April 2023, the corporation tax rate will increase on a sliding scale from 19% to 25% for companies with taxable profits over £50,000. Additional tax will be due on profits, meaning less distributable reserves and cash available to pay as dividends. However, an increase in tax rate means an increase in the relief for salary or bonus payments and employer’s NICs, if payable.
