Limited Companies - Salary vs Dividends
This is a common question that I get asked by business owners - should I pay myself a salary or dividends or a combination of the two?
It is an important, if not the most important, aspect to consider when setting up a limited company. Just a note - if you are a sole trader or partnership this article doesn't apply to you.
This article is not intended to encourage directors to reduce their tax liability but simply set out the options available while ensuring all relevant legislation is complied with.
Scenario One - Paying yourself a salary.
Business A Ltd records a total profit of £50,000 for the year for the purposes of Corporation Tax.
The sole director of Business A is going to pay themselves a salary of £30,000.
PAYE is due on the salary of £30,000 as follows;
Income Tax is due above the personal allowance of £12,500 at 20% = £30,000 minus £12,500 = £17,500 x 20% = £3,500.
National Insurance (Class 1 - Employee) is due above £9,504 at 12% = £30,000 minus £9,504 = £20,496 x 12% = £2,459.52.
National Insurance (Class 1 - Employer) is due above £8,784 at 13.8% = £30,000 minus £8,784 = £2,927.80.
In total the company has paid out £32,927.80, this counts as an expense for Corporation Tax purposes.
Therefore profit is reduced to £17,072.20 on which Corporation Tax of 19% is taken totalling £3,243.72.
Total tax paid = £12,131.04.
Scenario Two - Paying yourself through dividends.
Business B Ltd also records a profit of £50,000 for Corporation Tax purposes.
The sole director of Business B is going to pay themselves dividends of £30,000.
At this stage its important to note that it is illegal for business owners to pay themselves a dividend that is more than profit after Corporation Tax. However, if the company has been trading for a number of years then retained earnings can be used for this purpose. In this example we are satisfied that profit after Corporation Tax will be £40,500 which is more than total dividends of £30,000.
To issue a dividend a meeting of directors has to be held to declare it (even if there is only one director). For each payment a dividend voucher needs to be issued, keep this as a record. Dividends are distributed based on the percentage ownership of a company - so if you own 50% of a company you should receive 50% of the dividend distribution. In this example there is just one director.
You can earn up to £2,000 in dividends tax free on top of the personal allowance of £12,500.
Dividend tax at 7.5% is therefore due on dividends of £15,500 (£30,000 minus £14,500) totalling £1,162.50.
No National Insurance is due in this example (this does also mean you wouldn't get the benefits of paying National Insurance).
Dividends paid do not count as a business expense for Corporation Tax purposes so profit remains at £50,000. Corporation Tax is due at 19% of £50,000 totalling £9,500.
Total tax paid = £10,662.50.
Scenario Three - Combination of salary and dividends.
Business C Ltd records a profit of £50,000 for Corporation Tax purposes.
The sole director of Business C is going to pay themselves a salary of £8,783 and dividends of £21,217 totalling £30,000.
The salary of £8,783 falls below both National Insurance Class 1 thresholds (Employer and Employee) so no National Insurance is due. However, it is above the lower earning limit (LEL) so the director gets the benefits of National Insurance.
The salary also falls below the £12,500 personal allowance so no Income Tax is due. As the salary uses up £8,783 of the personal allowance only £3,717 remains for the purpose of dividends.
Dividend tax is due on £15,500 of dividends (£21,217 minus £2,000 dividend allowance minus £3,717 remaining personal allowance) at 7.5% totalling £1,162.50.
In addition, Corporation Tax is due on profits of £41,217 (£50,000 minus £8,783 salary paid) at 19% totalling £7,831.23.
Total tax paid = £8,993.73.
Which option you choose will depend on your businesses financial position as the calculations will vary for every business. Remember, any dividends paid must be administered correctly and not exceed profit after Corporation Tax. If you are paying yourself a salary I recommend using Xero cloud accountancy software (www.xero.co.uk) to ensure payroll is processed correctly.