Dividends versus salary for director-shareholders: the new rules
The new dividend tax rules have reduced the benefit of paying dividends instead of salary for many shareholder-directors, but dividends still have advantages.
Since 6 April 2016, dividends no longer come with a 10% tax credit. Instead, all individuals receive a dividend allowance so that the first £5,000 of dividends are taxed at 0%. They then pay 7.5% on dividends that fall within their basic rate band, 32.5% in the higher rate band and 38.1% in the additional rate band.
These tax rates on dividends are lower than the income tax rates on earnings, but that’s not the whole story. Salary payments reduce the company’s corporation tax liability, but paying dividends does not. On the other hand, salary carries liability for national insurance contributions (NICs) – avoiding NICs remains one of the main attractions of dividends.
The difference that the new dividend tax rules will make to shareholder-directors will depend on their circumstances. It’s important to look at the overall tax cost of paying a shareholder from the view point of both the individual and their company. A key variable is the amount taken as dividends compared with salary and bonus. Remember that salary/bonus is taxed before dividends, so your salary/bonus is set against your personal allowance first before your dividends are subject to tax.
For example, a shareholder-director takes a salary of £50,000 and has £40,000 of company profit available to fund a bonus or dividend on top. This person will pay no tax on the first £5,000 of their dividend and then 32.5% on the remaining £35,000, because their salary alone puts them into higher rate tax.
- Salary: £40,000 of profit would fund a salary of £35,149 after employer’s NICs, which after 40% tax and 2% employee’s NICs leaves a net salary of £20,386.
- Dividend: the company could pay a dividend of £32,000 after deducting 20% corporation tax. The first £5,000 would be tax free and then £27,000 would be taxed at 32.5%, leaving £23,225.
Some owner-directors take an annual salary of £8,060 to avoid employee’s NICs, and draw the rest of their income as dividends. This is still worthwhile but the new rules for taxing dividends will hit them harder. After the first £5,000 tax-free allowance, they will now pay 7.5% on the dividends that fall within the basic rate band, compared with no tax previously because the dividend tax credit used to cover the basic rate tax liability. The higher rate for dividends remains at 32.5%, but there is now no tax credit to reduce it. In most cases, there is still a saving compared with salary, although it is marginal at the additional rate of tax.
The dividend allowance is valuable and it will generally be worth paying shareholders dividends of up to £5,000. Spreading shares among family members will add to the benefit. Remember, however, that companies affected by the personal services company rules (IR35) will be limited in what dividends they can legitimately pay.
Another way of saving tax is to leave profits in the company if you do not need to withdraw them immediately. Retained profits are subject only to 20% corporation tax and provide the company with working capital. You might be able to withdraw profits in a year when you are taxed at a lower rate. Alternatively, if you come to sell the company, they might end up being reflected in the value of the company’s shares and in effect, be subject to capital gains tax at 10%.
One of the most efficient ways of benefiting from company profits is to make pension contributions as they are usually fully deductible in calculating the profits subject to corporation tax.
The best option in each case depends on several factors, so please come to us for advice tailored to your needs.
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