Lee Sharpe looks at some important considerations in seeking to optimise salary and dividends in 2020/21.
This article looks at securing the best combination of salary and/or dividends for director/shareholders of their own companies. Please note that COVID-19 (Coronavirus) has caused the government’s budgetary policy to shift frequently and substantially, and this may affect the considerations below.
For the purposes of this article, the following assumptions are made:
- The taxpayer is below state pension age and subject to National Insurance contributions (NICs) as normal, ignoring adjustments for apprenticeships, etc;
- There is no ‘other’ income of any significance;
- The many income adjustments potentially applicable such as student loans, pension contributions, ‘marriage allowance’ or high-income child benefit clawback are ignored in the calculations;
- The taxpayer is not subject to the Scottish income tax rates (although this will not change the results significantly).
Why pay salary?
The key reason for paying a salary is that it ‘earns’ a credit towards the state pension, provided the salary is sufficient. Earnings must achieve at least the lower earnings limit for the year, even if they do not exceed the primary threshold at which employee National Insurance contributions (NICs) become due.
The lower earnings limit is also the minimum for establishing eligibility for statutory sick pay (SSP) – which may become increasingly relevant due to the onset of the COVID-19 pandemic (and remember that, as an emergency measure for 2020/21, employers with fewer than 250 employees will be able to recover their SSP costs for the first 14 days of absence – per employee – due to COVID-19).
2020/21 Lower Earnings Limit £6,240
Primary Threshold £9,500
Readers may recall that, late in 2019, the government revealed an ‘aspiration’ to align the NICs threshold with the tax-free personal allowance. So far, this has resulted in a significant rise in the primary threshold to £9,500 (it was £8,632 last year). So, that is a decent increase in the threshold before employee NICs are physically payable. However, salary at or exceeding the lower earnings limit will still ‘earn’ a credit towards state pension entitlement, and that increased only slightly.
One of the consequences of the government’s focus on increasing the primary threshold is that it appears to have forgotten the secondary threshold – the point at which employers become liable to pay NICs. Last year, the primary and secondary thresholds were aligned – so employees’ and employers’ NICs were triggered at the same level of salary – but for 2020/21 the secondary threshold has risen to just £8,788.
This means that in 2020/21 (unlike in 2019/20) it will be possible to trigger a liability to employers’ NICs before employees’ NICs arise; salaries exceeding £8,788 but not £9,500.
|
Example 1: No NICs payable Edwina is the sole director and shareholder of Cosmopolitan Comics Limited. In 2020/21, she draws a salary of £8,760, or £730 a month. This level of earnings comfortably exceeds the lower earnings limit of £6,240, so Edwina will ‘earn’ a credit for state pension entitlement for 2020/21. But it is just less than the 2020/21 secondary threshold, of £8,788, so no NICs will actually be due. If Edwina paid herself a salary of anywhere up to around £790 a month (or £9,480 a year), only employers’ NIC would be due. |
Why pay salary instead of dividends?
Dividends are usually paid to all shareholders in proportion to their respective holdings. A bonus can be paid without regard to anyone else’s remuneration. Where there are several shareholders, some shareholders may need to waive some or all of their respective dividend entitlements to get the desired level of dividends. But shareholders do not always agree!
While salary or wages ‘earn’ entitlement to the state pension, they are also deductible for corporation tax purposes (strictly speaking, wages must still be paid ‘wholly and exclusively for the purposes of the business’, but in a family company this is generally problematic only if HMRC thinks a salary payment to a spouse, civil partner or close family member is excessive for the work done in return, and is really a payment to or for the benefit of the director/shareholder).
By contrast, dividends are paid out of the company’s residual profits after corporation tax – what is left over after everything else has been paid for. The company therefore gets tax relief for salary and wage payments, but not for dividend payments.
|
Example 2: Low salary: Effect on individual and company Anakin is sole director and shareholder of Vader Records Limited, and pays himself a salary of £8,760 for the year. With a standard PAYE tax code for 2020/21 of 1250L, he can earn up to £12,500 without having to pay any income tax, and his company will get tax relief for the salary paid to him. If he draws a salary of £8,760 he will pay no NICs, his company will pay no NICs, there will be no PAYE income tax, and the company will reduce its corporation tax bill by £8,760 x 19% = £1,664. |
So why pay dividends?
Dividends are still taxed relatively lightly where they fall in the basic rate band and are free of NICs.
Let’s say that Anakin draws a dividend of £2,000 a month on top of his salary of £8,760:
| 2020/21 | |||
| Tax Rate | £ | £ | |
| Income | Tax | ||
| Salary | 0.0% | 8,760 | - |
| Dividend in rest of personal allowance | 0.0% | 3,740 | - |
| Standard tax-free personal allowance | 12,500 | ||
| Balance of dividend: | |||
| New 'dividend allowance' | 0.0% | 2,000 | - |
| Balance of dividend | 7.5% | 18,260 | 1,370 |
Across his company and Anakin combined, he has managed to withdraw £31,390 after tax, etc., net of a personal tax cost of £1,370.
Let’s say that Edwina (from Example 1) takes a bonus of £24,000, on top of her original £8,760:
| 2020/21 | |||||||
| £ | £ | £ | £ | £ | |||
| Employee | Employer | Tax | Anna | Exodus Ltd | |||
| Salary plus bonus | 32,760 | 32,760 | 32,760 | 32,760 | ( 24,000) | ||
| Primary & secondary NI threshold; Personal allowance | ( 9,500) | ( 8,788) | ( 12,500) | ||||
| 23,260 | 23,972 | 20,260 | |||||
| NIC rates/tax rate | 12.0% | 13.8% | 20.0% | ||||
| NICs cost/income tax cost | ( 2,791) | ( 3,308) | ( 4,052) | ( 6,843) | ( 3,308) | ||
| Anna gets net, in her hand: | 25,917 | ||||||
| Extra cost to company of bonus: | ( 27,308) | ||||||
| Corporation tax (saving at 19%) | 5,189 | ||||||
| At a combined cost of: | |||||||
| Employees' NICs | 2,791 | ||||||
| Employers' NICs | 3,308 | ||||||
| Income tax | 6,843 | ||||||
| Less: Corporation tax (saving) | ( 5,189) | ||||||
| Total: | 7,754 | ||||||
Edwina has managed to withdraw only £25,917 after tax and NICs, at a cost of £7,754 across her and her company.
(Note: This includes the corporation tax saved only on the extra £24,000 in bonus, over and above the £8,760 salary paid already in both Edwina’s and Anakin’s original scenarios).
In other words, paying the additional funds as salary instead of as dividends has cost Edwina significantly more paid over to HM Treasury, and she has ended up with considerably less.
Marginal rates
The table below compares the main marginal tax rates – the effective tax cost – of taking an extra £1 in bonus, or dividend, where the taxpayer is a basic rate, higher rate or additional rate taxpayer.
| Taxpayer is: | |||||||
| Basic rate | Higher rate (£50k+) | Additional rate (£150k+) | |||||
| Marginal tax rate | |||||||
| Bonus | 40.24% | 49.03% | 53.42% | ||||
| Dividend | 25.07% | 45.32% | 49.86% | ||||
Conclusion
Dividends are broadly advantageous when compared to a salary, particularly where they are taxed at only the basic rate. But salary is essential for earning NICs credits, and tax relief for the company. Striking a balance, particularly where earnings are near a threshold, where child benefit, losses, pensions, gift aid and/or student loans are concerned, can involve some expertise.
However – and simply put – dividends can be paid only when a company has the profits available to distribute them. Where a business has already distributed previous years’ profits as dividends, etc. – and given the possible impact of COVID-19 on results in the coming year – it may be that shareholder/directors have less flexibility in their remuneration packages than they have had in previous years – business owners should speak to their advisers to ensure that they are not storing up tax problems by assuming that they can carry on with their dividend plans as normal.
