Sarah Bradford explores the optimal salary level for 2016/17 in the light of recent changes to the employment allowance and the rules for taxing dividends.
Traditional profit extraction strategies for family companies are based on taking a small salary to maintain your contributions records and extracting profits above that level. To ensure that the year counts for contribution purposes, the salary needs to be at least equal to the lower earnings limit for Class 1 National Insurance contributions (NICs). For 2016/17, this is set at £112 per week - equating to an annual salary at least £5,824 for the tax year.
From 2016/17, the National Insurance employment allowance is no longer available where the sole employee is a director. This means that one man companies (such as a typical personal service company) no longer qualify.
Consequently, the optimal salary for 2016/17 will depend on whether or not the employment allowance is available.
Scenario 1 – Employment allowance is not available
This will be the case in a one-man company where the employee is the sole director (or where the employment allowance is used up elsewhere).
It is assumed that the director has no other income and the personal allowance is fully available.
The maximum salary that can be paid free of NICs is equal to the lower of the primary and secondary threshold – for 2016/17, this is equal to £8,060 a year. At this level, the salary can also be paid free of tax (as it is covered by the personal allowance). The salary is deductible for corporation tax purposes (generating a tax saving for the company of £1,612).
However, mathematically, a marginally better result can be achieved by paying a salary equal to the secondary threshold of £8,112 per year. Although employee contributions are payable to the extent the salary exceeds £8,060 – giving rise to a NIC bill of £6.24 a year (i.e. 12% (£8,112 - £8,060)), the additional salary in excess of the primary threshold (i.e. £52) is deductible for corporation tax purposes, generating a corporation tax saving of £10.40 (i.e. £52 @ 20%). Consequently, there is an overall saving of £4.16 by paying a salary of £8,112 rather than one of £8,060. However, as this necessitates the hassle of paying primary NICs of £6.24 over to HMRC, it is probably not worth it.
Tip:
Where the employment allowance is not available, for practical purposes the optimal salary is £8,060 a year. However, it is possible to save an additional £4.16 by paying a salary of £8,112, but this is perhaps more hassle than it is worth!
Scenario 2 – Employment allowance is available
This will be the case if there is more than one employee (or the only employee is not also a director). It is assumed that the employment allowance is not fully utilised elsewhere.
The availability of the employment allowance makes it beneficial to pay a salary equal to the personal allowance - £11,000 for 2016/17. Although employee’s NIC is payable on the salary in excess of the primary threshold (£8,060), the employer’s NIC liability that would otherwise arise on the salary in excess of £8,112 (i.e. £398.54, being 13.8% of £11,000 - £8,112) is covered by the National Insurance employment allowance.
At a salary of £11,000, employee NICs of £352.80 (12% (£11,000 - £8,060)) is payable.
However, as salary is deductible for corporation tax purposes, the additional salary of £2,940 (£11,000 - £8,060) paid in excess of the primary threshold saves corporation tax of £588 (£2,940 @ 20%). This more than outweighs the employee’s NICs of £352.80, generating an overall saving of £235.20.
It is not worth paying a salary in excess of the personal allowance even if the employment allowance is available. Any salary above the personal allowance will be taxable and the combined effect of tax at 20% and employee’s National Insurance at 12% will outweigh the corporation tax saving of 20%.
Tip:
If the employment allowance is available, the optimal salary is equal to the personal allowance of £11,000 (assuming this is not utilised elsewhere).
Special cases – Director under 21
No employer NICs are payable in respect of an employee under the age of 21 until the employee’s earnings exceed the upper secondary threshold for under 21s of £43,000. Therefore, where the director is under 21, the optimal salary is equal to the personal allowance of £11,000, even if the employment allowance is not available.
Practical Tip:
As a general rule of thumb, the optimal salary (for 2016/17) is £8,060 if the employment allowance is not available, and £11,000 if it is (or the director is under 21) – but remember to take all personal circumstances into account.
