A salary is a payment made to the director by the company through PAYE. It is deducted as an expense in the accounts and therefore reduces the amount of corporation tax that the company has to pay. The salary is paid gross, usually on a monthly basis. The director pays tax and employee national insurance contributions (NICs), and the company pays employers NICs (subject to the level of salary).
The level of salary that is paid is dependent on several factors such as, the director’s attitude towards risk, state pension, national minimum wage rules, private pension, state benefit entitlement and other income earned in the tax year.
PAYE also affords other benefits such as statutory sick pay (SSP), statutory maternity pay (SMP) and statutory paternity pay (SPP).
Dividends are a reward to the shareholder for their investment and are paid from retained profit.
Where a dividend is paid, the dividend generates a “notional” tax credit which covers the personal tax liability in the basic rate tax band.
The basic rate tax threshold is £34,370*, and the personal tax free allowance is £8,105*, totalling, £42,475* in the tax year, that can be earned with no tax or NICs due by the director, therefore making dividends an attractive form of income.
The higher rate of tax payable on dividend income is 22.5% (net effect 25%), and 32.5% (net effect 35%) on incomes over £150,000*. NICs are not due.
Strategy – Director
An effective remuneration strategy will combine a salary with dividends and will utilise the £42,475* lower tax rate threshold. For effective tax planning, the director’s total income from all sources (salary, dividend, rental income, investment income, and any other salary and bank interest) should be calculated before 5th April tax year end. Any amount under the threshold not paid should be taken as a dividend provided there is sufficient retained profit available.
Where personal income above the threshold is not required to live off, it may be prudent to leave it in the company to avoid paying tax at the higher rate.
Joint Strategy between Director and Spouse
It is possible to have a spouse as a shareholder and pay them dividends and a salary. Consideration needs to be made on whether the spouse has other income, and at what amount.
Any salary should be paid at market rate commensurate to the duties performed for the business.
Where the spouse is a shareholder, each time a dividend is raised, they also receive a dividend according to their share split.
With joint shareholdings it is possible to achieve joint earnings of £84,950* annually, and the shareholders will not have any personal tax or NICs to pay. However, this is a high risk strategy and only possible for new companies. Older companies would be endangered by the “settlement legislation”. Please seek professional advice from us before structuring the company in this way.
Attitude towards Risk
When considering a director’s remuneration strategy between salary and dividends, the decision is unique to the director and should be based on their attitude towards risk. The higher the salary paid, the lower the level of risk.
A low risk strategy would entail paying an annual net salary commensurate to the amount that the director requires to live off with infrequent dividends.
A high risk strategy would pay a salary set in line with the Lower Earnings Limit (LEL) for NICs with frequent dividend payments.
HMRC lose millions of pounds in revenue each year through NICs not being paid on dividend income. With this in mind, they could seek to apply class 1 NICs on income where they can prove that the dividends were “disguised remuneration” taken to boost income where a low salary is paid. However, at present, such an attack would be highly unlikely.
State Pension Requirements
If you are a UK National entitled to the state pension, you are required to have National Insurance Contribution (NICs) credits for 30 qualifying years to earn the full pension entitlement.
Where a salary of £5,564* (the LEL of NICs) is paid annually, the state pension will receive the year’s credit but no NICs will be paid by the director or company, thus making them “free” contributions.
If the salary level is below this amount, or no salary is paid, the pension fund will lose the credit for that year. It is possible to purchase voluntary NICs retrospectively for up to 6 years. However they are purchased on a weekly basis and are costly. You can find further information and request a pension forecast from the Direct Gov website.
Individual’s contributions made to a personal pension plan have restrictions of tax relief at the basic rate and require a salary set to a level to fund the contributions. Company pension schemes do not afford the same restrictions and total tax relief can be obtained. It is advisable to take professional advice from an independent advisor on the most tax efficient solution.
National Minimum Wage
If the director has an employment contract with their limited company, they are obliged to conform to the National Minimum Wage (NMW) regulations. An hourly rate of £6.08* is payable for ages 21 and over and £4.98* for 18-20 year olds.
Where there is no employment contract present for a director, then NMW rules are not obligatory.
Personal or Company Pension
Advice needs to be taken from an independent financial adviser prior to setting a salary level. Many schemes require a salary equal to the annual contributions.
Working Tax Credit and other State Benefits
Where a director is claiming Working Tax Credits or other benefits such as statutory sick or maternity pay, then the NMW rules will apply. The number of hours worked will form part of the entitlement and advice should be sought to plan accordingly. There should also be an employment contract in place.
Previous Salary in the Tax Year
If the director’s earning through PAYE from a previous employment have exceeded £5,564* in the tax year commencing 6th April, it may not be tax efficient to pay any salary from the limited company until the new tax year commencing 6th April. The state pension fund will receive its NICs credit and no further tax will be due.
*Bands, Rates and Allowances refer to tax year 6th April 2012 to 5th April 2013
This brief is for guidance purposes only. In all cases we would recommend that you discuss any queries with professional advisers. Please feel free to contact us if you have any questions.