Updated 20 April 2015: amended to include 2015/16 figures
A common and sensible question that small business owners trading through a limited company often ask is ‘how do I pay myself in the most tax efficient way’?
The answer to this question is refreshingly simple: use a mixture of salary and dividends.
Salary is the term used to describe money paid to you as an employee of the company. Money paid in this way must be taxed at source (i.e. by the company before it is passed to the employee). This scheme is called PAYE (Pay As You Earn) and ensures that companies deduct both income tax and national insurance from employees salaries and pay it directly to the tax man.
Pay £671 per month as salary
Optimising salary is mainly about National Insurance thresholds. You need to pay enough salary to avoid gaps in your record but not so much that you start to incur National Insurance payments. In most cases you should pay yourself a small salary that falls below the ‘upper earnings limit’. For the tax year 2015/16 this figure is £671 per month.
Dividends are a distribution of profits by a company to its shareholders. As this definition suggests, dividends should only be paid if there is sufficient profit in the company to cover the payment.
Profits are taxed at 20%
The profits of a company are taxed through the Corporation Tax system. For small companies this is at a rate of 20%. So any money available for dividend payments will already be liable to tax at 20%, which must be paid by the company.
Individuals pay no additional tax on dividends received from the company
Until an individual’s income exceeds the higher rate tax threshold (a total salary of £42,465 for 2015/6) dividends are taxed at only 10%. However, the tax man has decided that it would be unfair to tax this money twice (once when it becomes profit and once when it is distributed to individual shareholders) so individuals can claim a ‘tax credit’.
Don’t worry about tax credits
Tax credits on dividends are difficult to understand. You don’t really need to worry too much about it, but it is helpful to understand that the cash paid out to you by the company technically only represents 90% of your ‘dividend income’. The other 10% is a notional tax credit that is never actually paid but is relevant for your tax return.
The important thing is that the tax has already been paid by the company so whatever cash you get from the company you can keep! The important caveat to note however is that once your taxable income exceeds the higher rate tax threshold (set out above), you will incur additional tax at 25% on the cash dividend you received that exceeds the threshold.
Example of tax efficient payment
- A total of £46,904 from the company is paid out as follows:
- Salary of 12 x £671 = £8,052
- Company profits of £38,948, subject to tax at 20%, leaves dividends to pay to you of £30,158
- So total net income = £38,210 (total taxable income = £41,561, just below the higher rate threshold).
On this basis the effective tax rate is 19% which compares favourably to the 27% you would pay if you put all this cash through as salary (or 38% if you include the employer’s NI contributions). Note that the benefit deceases as your dividend payment exceeds the amounts above because you start to pay the additional 25% tax.
If you use a good piece of accounting software (check out our ClearBooks review here) then this should create Dividend vouchers for you. Technically you should also approve the payment of dividends at a board meeting and create an official board minute recording this. The belt and braces approach would be to staple a set of management accounts showing sufficient profit to the voucher and board minute. As to how many companies actually do this, I couldn’t possibly speculate
If you want to find out more about day to day management accounting, check out my post on the basics of management accounting for small businesses.
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