Updated 29 June 2013: amended to include 2013/14 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 £641 per month as salary
In most cases you should pay yourself a small salary that falls below the threshold for Income Tax and National Insurance. For the tax year 2013/14 this figure is £641 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 40% rate tax threshold (£41,451 for 2013/14) 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!
Example of tax efficient payment
- A total gross income of £49,890 is paid out as follows:
- Salary of 12 x £641 = £7,692
- Company profits of £42,198, subject to tax at 20%, leaves dividends to pay to you of £33,758
- So total net income = £41,450
On this basis the effective tax rate is 17% which compares favourably to the 28% you would pay if you put it all through as salary (or 40% if you include the employer’s NI contributions).
Note that the situation becomes slightly less beneficial if you exceed the gross income level of £49,890 because this pushes you into the higher rate tax bracket. However, the same structure will still probably save you money.
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.