Alan Pink considers the position in relation to payments of salary and dividends to company owners for 2023/24.
Directors of owner-managed or family companies commonly take their profit out of the business through a mixture of salary and dividends.
It’s an article of faith with many businesspeople that if you’re going to run a business, this should be through a limited company. Even with the increase in the top corporation tax rate to 25% from April 2023, company tax on profits is likely to be substantially less than the same profits would be bearing as income tax if the business were carried on as a sole trader, partnership, or limited liability partnership.
Decisions, decisions…
However, what I’ve called the classic conundrum arises where the director-shareholders of the company want to take money out for their own private use. Should this be as salary, dividends, or something else? Anything I say here has got to be subject to the caveat, of course, that individual circumstances vary widely, and there is no substitute for ‘doing the sums’ in each case to see how the individual can end up with the most money after all taxes and other government levies.
Another caveat I have to enter here is that the position I’ll be describing is based on the tax rates that are currently announced for the year ended 5 April 2024 and, of course, anyone who has been following the story to date will be aware of the bewildering series of U-turns that the government has made on such a straightforward matter as the tax and National Insurance contributions (NICs) rates that individuals (and companies) will be paying in the near future. Tax planning at the moment is like a game of football where the goalposts are constantly swaying drunkenly from side to side. So, do check what the numbers finally end up being set at when the Finance Act 2023 ultimately writes them in stone.
Dividends vs remuneration
It’s probably the case that most owner-managed or family companies adopt a straightforward mix of dividends and remuneration, for the purpose of rewarding their director-shareholders from month to month and year to year. So, the conundrum is: what should be the mix of dividends and remuneration to give the smallest share of a director’s hard-earned money to the government?
The problem arises because both forms of income payment have their drawbacks. At one time, the clear policy objective of dividend tax rates was to put individuals in the same position after tax, whether they passed their income through a company or took it direct. In simplistic terms, an amount of profit of 100 would at one time have borne corporation tax of 20, and then income tax on the dividend of the remaining 80 amounting to another 20 if the shareholder receiving the dividend was a higher rate taxpayer. This was exactly equivalent overall to the 40% tax that the individual would have paid if they had simply received the income direct (as a sole trader or partner). So, the tax system was deliberately steering clear of making the question of whether you trade through a limited company or not, one that was heavily loaded by tax planning considerations.
This is certainly far from being the case now, and without going into tedious numerical detail here, the basic reason is that the current rates of dividend tax (8.75% for a basic rate taxpayer, 33.75% for a higher rate taxpayer, and 39.35% for an additional rate taxpayer) do not compensate the individual shareholder fully for the fact that the income has already been taxed at company level. The rates are lower, it’s true, than the 20%, 40%, and 45% rates that would apply to most other types of income, but the reduction does not fully compensate any more for the corporation tax that has already been paid.
Wastage of the personal allowance
It is now a very long time since the ability to reclaim tax credits on dividends was abolished, and so a further tax-driven distortion of individual financial behaviour was introduced, because it was effectively no longer possible to get back the corporation tax that had been paid on income which was then paid out to shareholders within their personal allowances (currently £12,570 a year). So, what might be called the ‘standard’ solution to the classic conundrum arose, which was paying part salary and part dividend, with the salary part being generally a comparatively small amount within the individual’s personal allowance.
This is where a fairly neat bit of NICs planning comes in. If you cast your eye over the official NICs rates on the internet or in tables, you will see a bewildering array of different weekly, monthly, and annual thresholds and limits; but the important two to look at for this purpose are the lower earnings limit and the primary threshold. Earnings over the lower earnings limit will make the year count towards the state pension, which you hope ultimately to receive but contributions do not actually become payable until earnings have gone above the somewhat higher primary threshold.
The big change here is that the primary threshold has been increased (at the time of writing) so that it’s equal to the personal allowance, which is £12,570 a year. So, in many circumstances commonly found in practice, it will be best to pay up to the personal allowance in salary, with the balance in dividends.
Exceptions that prove the rule
However, as mentioned you need to look at everyone’s particular circumstances. Here are a number of situations where this nice simple formulation I’ve set out will not apply:
- Where an individual has personal losses to offset, which might be more tax efficiently offset against salary income than dividend income.
- Where the individual is likely to be wanting to apply for a mortgage or other personal loan, and the success or otherwise of this application depends on their reported earnings. I’m told that lenders will sometimes insist on earnings (that is, in this context, salary) rather than dividends to support the individual’s claim to be able to sustain the mortgage repayments, etc.
- Where the individual wants to make personal pension contributions, that can only be made out of earnings and cannot be made out of dividends.
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Not all situations are as simple as the situation of the single (or married etc. couple) choosing between salary and dividends. Where there is more than one director-shareholder, and they are not closely related, it may be that the person who is earning the most money is not the person who has a corresponding majority of the shares, so it’s necessary to pay that person in salary as a matter of commercial fairness. If this becomes an expensive issue in tax planning terms, though, it would be possible to consider alternative and more complex arrangements, such as the personal service company structure, whereby the individual concerned charges the company through his own captive vehicle. This is too big an issue to consider in this article; but it could be worth looking at with the benefit of proper professional advice!
Other forms of profit extraction
Finally, do not forget that the straightforward binary choice between salary and dividends may be an oversimplification. There are all kinds of other ways of taking money out of a company and, depending on the circumstances, these could be much more tax-efficient, including:
- repayment of directors’ loan accounts and other amounts owed by the company to the individual;
- payment of interest on loans by the individual to the company if you’re not repaying this loan;
- payment of rent on premises occupied or part-occupied by the company;
- sale of assets to the company in return for money paid by the company to the individual; and
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a loan by the company to the individual.
Whilst the last mentioned arrangement is technically voidable by the company, and in that sense ‘illegal’, the tax consequences are a kind of repayable deposit with HMRC by the company amounting to 33.75% of the loan, which can sometimes be a much better deal ultimately, because it’s repayable rather than suffering either the dividend tax or the NICs paid on a salary.
