Sarah Bradford explores the tax consequences of taking dividends or a salary/bonus from a personal or family company.
A company is a separate legal entity, and if you operate your business as a personal or family company you will need to extract the profits if you want to use them for your personal use.
There are various ways of doing this, including taking a salary/bonus or paying dividends, and the associated tax consequences will vary with the method chosen. For 2023/24, the changed corporation tax regime adds a new dimension.
This article looks at the tax implications of different profit extraction strategies.
Corporation tax changes
From 1 April 2023, the rate at which a company pays corporation tax depends on the level of its taxable profits and whether it has associated companies.
From that date, corporation tax is payable at the rate of 19% where profits do not exceed the lower limit (set at £50,000 for a company with no associates) and at 25% where profits exceed the upper limit (set at £250,000 for a company with no associates).
Between these limits, the company will pay corporation tax at the rate of 25% less marginal relief. The company’s effective rate of tax will be between 19% and 25% depending where in the band the taxable profits fall. Where the company has at least one associated company, the limits are divided by the number of associates plus one (so for a company with one associated company, the lower limit is £25,000, and the upper limit is £125,000). The limits are also proportionately reduced where the accounting period is less than 12 months.
Where the accounting period spans 1 April 2023, the profits are apportioned to the period before this date and the period falling on or after that date and are taxed at the prevailing rates.
Companies whose taxable profits are more than the lower limit will pay corporation tax at a higher rate from 1 April 2023. This will reduce their post-tax profits and the profits that they have available from which to pay a dividend.
Paying a small salary
A well-documented tax-efficient profit extraction strategy is to take a small salary and extract any further profits as dividends.
For 2023/24, the personal allowance and the primary threshold are aligned, both being set at £12,570. For 2023/24, the optimal salary is £12,570, assuming that the personal allowance remains available in full. At this level, the director-employee will not pay any income tax or primary Class 1 National Insurance contributions (NICs).
If the employment allowance is not available and none of the higher secondary thresholds applies, employer NICs will be payable at 13.8% to the extent that the salary exceeds the secondary threshold (£9,100 for 2023/24). Where a salary equal to the personal allowance is paid, the secondary Class 1 NICs hit for 2023/24 is £478.86. However, this is deductible for corporation tax purposes (as is the salary), making it more tax-efficient to pay a salary of £12,570 than one equal to the secondary Class 1 NICs threshold of £9,100.
If the employment allowance is available to set against the employer contributions, there will be no secondary Class 1 NICs to pay. However, the employment allowance is not available to companies where the sole employee is a director, so personal companies rarely qualify. Family companies with more than one employee can claim the allowance.
If an annual bonus of £12,570 is paid instead of a salary, the tax consequences are the same.
Paying a salary or bonus that is at least equal to the lower earnings limit (£6,396 for 2023/24) has the added benefit of ensuring that the year is a qualifying year for state pension purposes. This is useful if the director-employee does not have the requisite 35 years needed for a full single-tier state pension.
Extracting further profits: bonus or salary?
If, after paying a small salary, further funds are needed outside the company, these need to be extracted. The main ways of doing this are by paying a bonus or taking dividends.
(a) Bonus
Although generally less tax-efficient than paying dividends, there are some circumstances in which it may be preferable to pay a bonus.
The bonus route offers more flexibility than the dividend route. Dividends can only be paid out of retained profits, whereas a bonus can be paid regardless of whether there are sufficient profits, even if this creates a loss. Further, dividends must be paid in proportion to shareholdings, but there are no corresponding restrictions on the payment of bonuses (other than those that may be set by the employment contract).
Where a bonus is paid, it is taxed at the recipient’s marginal rate of tax – 20% where it falls in the basic-rate band, 40% where it falls in the higher-rate band and 45% where it falls in the additional-rate band (applying for 2023/24 where taxable income exceeds £125,140).
Class 1 NICs may also be payable – primary contributions are due at 12% on earnings between the primary threshold (£12,570 for 2023/24) and the upper earnings limit (£50,270 for 2023/24) and at 2% where earnings exceed the upper earnings limit. Employer contributions are due on earnings over the secondary threshold of £9,100 at the rate of 13.8%. Remember, directors have an annual earnings period for NICs purposes.
The bonus and the employer’s NICs are deductible when calculating the company’s profits, so they will attract corporation tax relief at between 19% and 25%, depending on the level of the company’s profits. Paying a bonus will reduce the company’s taxable profits, and doing so may reduce the rate of corporation tax paid by the company.
The director’s bonus is taxed under PAYE, so there is no further tax to pay.
Example 1: Bonus to director
Having paid a small salary, a company has taxable profits for the year to 31 March 2024 of £80,000. The company decides to pay a bonus to the director.
The company must pay secondary Class 1 NICs on the bonus. The company can therefore pay a bonus of £70,298, on which the associated employer’s NICs is £9,702.
The bonus and employer’s NICs are deductible for corporation tax purposes, reducing the company’s profits to nil (i.e., £80,000 - £70,298 - £9,702). Consequently, the company pays no corporation tax.
The director has received a salary of £12,570, which has used up his personal allowance. He will pay tax of £20,579.20 on his bonus ((£37,700 @20%) = (£32,598 @ 40%)), plus Class 1 NICs of £5,175.96 ((£37,700 @ 12%) = (£32,598 @ 2%)). The director is left with £44,542.84 (i.e., £70,298 - £20,579.20 - £5,175.96).
(b) Dividends
Dividends benefit from lower tax rates, and for 2023/24 are taxable at 8.75% to the extent that they fall in the basic-rate band, at 33.75% to the extent that they fall in the higher-rate band and at 39.35% to the extent that they fall in the additional-rate band.
All individuals, regardless of the rate at which they pay tax, benefit from a dividend allowance. This is set at £1,000 for 2023/24, down from £2,000 for 2022/23. It is to be further reduced to £500 from 6 April 2024. The reduction in the dividend allowance reduces the opportunity to extract profits as dividends without triggering a further tax liability. Dividends covered by the allowance are taxed at a zero rate, but the ‘allowance’ uses up part of the tax band in which it falls (dividends being treated as the top slice of income).
Dividends can only be paid if there are sufficient retained profits from which to pay them. They must also be paid in proportion to shareholdings; however, the use of an ‘alphabet’ share structure can overcome this restriction.
Example 2: Dividend to director shareholder
As in Example 1, having paid the director a small salary of £12,270, a company has taxable profits of £80,000 for 2023/24. They wish to extract the post-tax profits as a dividend.
The company must pay corporation tax of £17,450 (i.e., £80,000 @ 25% less marginal relief of £2,550). Therefore, the company has post-tax profits of £62,550 to pay as a dividend.
The director must pay tax of £11,631.87 on the dividend (i.e., (£1,000 @ 0%) + (£36,700 @ 8.75%) + (£24,950 @ 33.75%)). After tax, the director is left with £50,918.13.
This is a better outcome than paying a bonus, as the director is able to keep £6,375 more of the profits.
Practical tip
Before making a decision about how to extract profits, do the sums. The best result will depend on the director’s personal circumstances and the rate at which the company pays corporation tax.
