Salary vs. Dividends: The Best Way to Extract Profit from Your Company

As a company owner, one of the most pressing questions is how to best extract profits in a tax-efficient manner. This choice often boils down to two primary methods: taking a salary or paying yourself dividends. Both approaches have their advantages and potential pitfalls, depending on your circumstances. Let’s delve into the intricacies of each option and explore strategies for optimising your tax position.

Understanding the Basics: Salary and Dividends

Salary is the compensation you receive as an employee of your company. It is subject to income tax and National Insurance Contributions (NICs) in the UK. The amount of tax paid depends on your income level, and NICs are due from both the employer and the employee.

Dividends, on the other hand, are payments made to shareholders from a company’s profits. Dividends are not subject to NICs, making them a potentially more tax-efficient way to extract profit. However, dividends are paid after corporation tax has been deducted, and the amount you can pay yourself depends on the company’s distributable profits.

The Tax Efficiency of Dividends

One significant advantage of dividends is their favourable tax treatment compared to salaries. For the 2020/21 tax year, individuals have a tax-free dividend allowance of £2,000. Beyond this allowance, dividend income is taxed at different rates depending on your total income:

• 7.5% on dividends within the basic rate band.
• 32.5% on dividends within the higher rate band.
• 38.1% on dividends within the additional rate band.

These rates are generally lower than the equivalent rates for income tax on salaries. Furthermore, since dividends are not subject to NICs, you can often take home more net income compared to receiving the same amount as a salary.

Optimal Salary and Dividend Mix

The most tax-efficient approach often involves a combination of a small salary and larger dividends. This strategy allows you to utilise your personal allowance (the amount of income you can earn before paying income tax) and avoid NICs on the dividend portion of your income.

Example Scenario:

Let’s consider a typical company owner. By setting a salary just above the lower earnings limit but below the primary threshold for NICs, you qualify for state benefits without incurring significant NICs. For the 2020/21 tax year, this threshold is around £9,500.

You can then pay yourself dividends from the remaining profits. For instance, a married couple in business together can receive up to £29,000 tax-free by taking advantage of both personal allowances and the dividend allowance. This income split strategy can significantly reduce your overall tax liability.

Factors to Consider Beyond Taxes

While tax efficiency is crucial, other factors must be considered when deciding between salary and dividends:

1. Pension Contributions: Salaries are pensionable earnings, making them crucial for accruing state pension benefits and contributing to a private pension scheme. Dividends do not count towards pensionable earnings, so relying solely on dividends could affect your future pension income.
2. Employment Rights: A salary provides entitlement to employment rights such as sick pay, maternity leave, and redundancy pay. Dividends do not offer these benefits, which may be a consideration for some company directors.
3. Cash Flow Management: Companies need sufficient distributable profits to pay dividends. If cash flow is tight, paying a salary may be more manageable since it can be treated as a business expense and deducted before calculating corporation tax.

Avoiding Common Pitfalls

While the small salary, large dividend approach is popular, it comes with potential pitfalls:

• Minimum Wage Regulations: Ensure that any salary paid meets the National Minimum Wage requirements if you have an employment contract.
• Distributable Profits: Only pay dividends from profits after corporation tax; paying illegal dividends can lead to significant issues with HM Revenue & Customs (HMRC).
• HMRC Scrutiny: HMRC may challenge arrangements that appear artificial or designed solely to avoid tax. It is essential to maintain clear records and ensure that salary and dividend decisions are made for commercial reasons.

Conclusion

Choosing the right balance between salary and dividends can be complex and depends on individual circumstances, including other income sources, business profits, and personal financial goals. Consulting with a tax advisor or accountant is advisable to tailor a strategy that optimises your tax position while considering broader financial planning needs.

At Certax Lancashire, we specialise in helping business owners navigate these decisions. Our expert team is here to guide you through the intricacies of tax-efficient profit extraction, ensuring you keep more of your hard-earned money while staying compliant with all tax regulations.