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Salary Versus Dividends- Plenty To Think About!

  • March 15, 2019
  • Issac Qureshi
  • Self Improvement, SME, Tax Relief

Issac Qureshi considers the situation as it currently stands regarding the extraction of income from a family company by way of salary or dividends.

The role of the accountant advising a family company is never dull, because of HMRC’s habit of moving the goalposts on a regular basis. The classic issue facing such accountants, where the directors and shareholders of a company are basically the same people, is whether income taken by them out of the company should be extracted in the form of salary or dividends. The two have very different tax and National Insurance contributions (NICs) treatments, and these have changed comparatively recently.  

Other profit extraction methods

Of course, any discussion of the relative merits of taking salary or dividends from a proprietary company needs to take into account the fact that these are not necessarily the only two ways in which profits can be extracted.  

For example, where the company occupies a property directly owned personally by the shareholder directors, the alternative of paying rent should always be considered. Alternatively, or additionally, where there is a director’s loan balance of a substantial enough amount standing to the credit of such individuals, the option of paying interest on that director’ loan account should be considered. Both of these methods of profit extraction have the advantage that no NICs liability applies. What’s more, the ‘dividend tax’ will also not apply to those profit extraction methods.

Sometimes, where the circumstances are right, it is also possible for shareholder directors to extract funds from the company in capital form; for example, by transferring some valuable asset, previously owned personally, to the limited company.

And of course, there is the option of restructuring your company and organisation in such a way as to allow you the ability to also reduce your taxation position through the use of ownership rules, legislation and allowances. Although on the fact of it, this may appear complex, it does provide a flexible and tax efficient solution to a number of organisations.

What follows assumes that none of these alternative options for profit extraction apply.

The basic framework

Even though, in an owner-managed business, remuneration and dividends can often be seen as more or less freely interchangeable as ways of taking money from the company, the two are treated very differently for tax purposes because of their originally very different characters.  

Remuneration is earned income for tax purposes; nowadays, the most important consequence of this is the fact that, as earned income, it gives rise to a liability to both employers and employees’ NICs. At top rates of 12% and 13.8% respectively, the NICs burden on remuneration is huge.  

This is the main reason, in a nutshell, why dividends are seen as an attractive alternative to remuneration. Despite fear a few years ago that aggressive planning using dividends was going to give rise to the imposition of NICs on dividend payments which overstepped the mark, it’s basically the case, at present, that dividends will not normally be attacked by HMRC in this way.  

Instead, as one of the recent goalpost moving exercises undertaken by the government, an effective surcharge on income taken as dividends applies. A basic rate taxpayer, receiving dividends over and above the £2,000 per person per tax year tax-free amount, will be liable to tax on those dividends at 7.5% (the old concept of a ‘tax credit’ applying to dividends has been completely scrapped). Someone in the equivalent to the 40% band of income tax will be liable at 32.5%, and a person whose income is more than £150,000 in a year and is therefore within the 45% band will pay 38.1%. These amounts are lower rates of tax because of the fact that dividends are paid out of post-corporation tax profits. Nevertheless, it’s not difficult to see that, if it were not for NICs, one would generally prefer to extract one’s profits from the company by way of remuneration because the dividend tax actually takes you, effectively, over the rate of tax you would otherwise have paid.  

For example, take a person whose income puts him into the 40% band, who receives a dividend from his company. The total tax can be worked out along the following lines (ignoring the £2,000 ‘dividend allowance.

Profits of the company 100%

Corporation tax at 19% (19%)

Therefore, payable as a dividend 81%

Personal tax at 32.5% (of £81)    (26%)

Therefore, available after tax 55%

You will see from this that an effective tax rate has been suffered of 45%, even though the individual concerned is (or should be) only a 40% taxpayer. So, arguably, passing the profits through the company has unnecessarily increased his tax liability by 5%.  

The usual strategy

Despite this, the damage caused by this extra tax levy recently introduced by the government is still less than would be caused by receiving these amounts as earned income and thereby incurring NICs.  

So, it’s very much a case of ‘the mixture as before’, with nominal amounts being paid as salary in normal circumstances, with the balance of the income taken out of the company by the shareholder directors as dividends.

The reason for the nominal salary is twofold; firstly, the salary has historically been taken because the personal allowance was not utilised by paying dividends. Secondly, incurring a small amount of NICs by paying a small earned income amount results in the year ‘counting’ for the purpose of various state benefits. In fact, there is a band of income at which NICs is not triggered, but the year nevertheless counts for NICs purposes.

Exceptions to the ‘normal’ strategy

We’ve talked gayly about choosing between salary and dividends as if these were in every way completely interchangeable. Such isn’t always the case, though.  

For example, it may be that the person who is doing most of the work and, therefore, is earning most of the income has a lesser amount of the company’s share capital. Therefore, dividends could not be payable to him in a sufficient amount to reward him for his ‘sweat’, without at the same time paying the lazier majority shareholder an even greater ‘reward’. This is often given as the reason for substantial director’s remuneration figures in practice. I think this is a mistaken view though, because it is usually quite easy to re-arrange the company’s share capital into different classes, so that dividends don’t have to be paid at the same rate on everyone’s shareholding.

Another frequently met exception to the rule which says dividends are better is where it is necessary for an individual to receive a substantial amount of earned income in order to support a mortgage application. Some lenders are fairly well removed from reality in their treatment of owner-managed businesses and will not lend on the basis of dividends because they are ‘investment income’ rather than earned income. So, someone trying to take out a large mortgage is faced with a stark choice: take a large amount of remuneration so that you can show the proposed lender a P60 and suffer the substantial NICs liabilities; or, if you possibly can, find a more intelligent lender!

If you would like to discuss your own tax scenario and look for ways of potentially reducing your exposure, then simply contact us for a no-obligation discussion.