A standard strategy for a small incorporated owner managed business or contractor is to extract profits from their company through a tax efficient mix of salary and dividends at the level of the higher rate income tax threshold of £42,385. For a sole director / shareholder who is entitled to the full tax free personal allowance and has no additional earnings, the most efficient approach is:
- Take a salary equivalent to the personal allowance of £10,600 so that no income tax becomes payable. As salaries are taken out of pre tax company profits, corporation tax of £2,120 will be saved (20% of £10,600).
- Claim the employment allowance which exempts an employer from paying the first £2,000 of their employer NI liability. Employee NI of £305 will however be payable on the excess of salary over the NI primary threshold of £8,060 at 12% (£10,600 – £8,060 at 12%). Net salary will be £10,295 (£10,600 – £305) and the director will receive NI credit for benefits including the state pension.
- Take gross dividends of £31,785 so that total gross income is equivalent to the higher rate income tax threshold (£42,385 – £10,600). Dividends are paid to shareholders net of a notional tax credit of 10% of the gross dividend – equivalent to 1/9 of the net cash amount actually received. Net (cash) dividends are therefore £28,607 (£31,785 less 10%). Gross dividends falling within the basic rate band are taxed at 10% – this tax charge is deemed to have been satisfied by the credit.
- Total funds extracted are £38,902 being net salary of £10,295 plus net dividends £28,607.
A common variant of the above is where a director does not claim the employment allowance even if they are entitled:
- A salary of £8,060 is taken incurring no income tax, no employer NI and no employee NI. The director will receive NI credit and corporation tax of £1,612 is saved (20% of £8,060).
- Take gross dividends of £34,325 so that total gross income is equivalent to the higher rate income tax threshold (£42,385 – £8,060). This equates to £30,893 in net dividends. The dividend income incurs no income tax.
- Total funds extracted are £38,953 being net salary of £8,060 plus net dividends £30,893.
This latter route is slightly less efficient:
- Total funds extracted are £51 higher (£38,953 – £38,902)
- Total taxes saved are £203 less – £508 less corporation tax is saved (£2,120 – £1,612) but £305 employee NI is not incurred.