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Dividends Vs Salary – the great debate

The choice of payment for company directors come down to three elements, salary, dividends or pension and due to the complexity of the tax system the decision isn’t always straightforward.

In this post, we’ll look at some of the issues around this and give you some things to think about.

Taking a salary

It’s always a good idea to take a salary as a company director.

Firstly, salary is an allowable business expense and so the company pays no corporation tax on the value of the payment. Individuals all have a tax-free allowance (£12,500 for 20/21 tax year) that also means that the payments up to the allowance ceiling will be tax-free for the director.

Companies are only allowed to pay a dividend if they have distributable profits, with a salary there is no such restriction and so a salary is often the right option for start-ups that are yet to make money.

Paying a salary through the PAYE system also means that the director builds up their NIC contribution record meaning that they are eligible for state benefits such as the pension and maternity pay in the future.

Having a record of salary payments makes life easier when applying for mortgages, personal critical illness cover and personal loans.

Tax relief on pension contributions can be limited to the amount of salary that the person makes and so having a healthy salary means that the contributions can be higher.

For small companies, directors will typically pitch their salary between the Lower Earnings Limit (currently £6,136) for NIC and the Tax threshold. This means that by paying NIC they build up a contributions record but don’t pay tax on their salary.

Dividends

Dividends are essentially a distribution of a company’s profits.

This leads to a major issue with dividends in that it is illegal to pay dividends if the company doesn’t have sufficient profits to do so.

Consequently, dividends are not suitable for companies that are in a start-up position that haven’t made profits or that only have a small amount of distributable profit.

This having been said, the profits do not have to be made in the same year as distribution but can have been built up for many years before. In this case, it is allowable for a company that has made a loss to still pay a dividend.

Dividends are payable from the post-tax profits of a business and so they will already have suffered corporation tax of 19% by the time it comes to distribution.

As a result, shareholders pay less personal tax on the dividends that they receive.

This also raises the issue that of course directors can only receive dividends in direct relation to the number of shares they hold in the company. For owner-managers, this is not an issue as they will likely hold 100% of the shares, but for companies where the shares are more widely held, dividends will have to be paid to all shareholders.

Additionally, NIC is not payable on dividend payments and taxpayers have an additional £2,000 tax-free dividend allowance which again makes them a very efficient method of payment.

The tax payable on dividends depends upon the taxpayer’s total income as per the table below.

 Basic rateHigher rateAdditional rate
Salary20%40%45%
Tax threshold:£12,500-£50,000£50,001 to £150,000£150,001+
Dividends7.5%32.5%38.1%
Tax threshold:£14,500-£50,000£50,001 to £150,000£150,001+

From a personal point of view, directors will often pay a lot less in tax and NICs by opting for a mix of a small PAYE salary and a dividend however it does need to be borne in mind that the company will, in turn, pay more corporation tax on the dividend payment.

Pension payment

Directors can also opt to receive part of their salary in the form of pension contributions.

Pensions are a very tax-efficient method of receiving remuneration as successive governments have sought to encourage people to plan for their retirement.

Pension contributions are an allowable expense for the business and as such do not suffer corporation tax. By the same token, there is no employer’s NIC (currently 13.8%) levied.

From a personal point of view pension contributions aren’t seen as income and as such, they don’t increase the director’s tax bill and as they are seen as employer contributions there is a high limit of up to £40,000.

This means that for directors who have chosen to take a very small salary, the company can still make healthy pension contributions on their behalf.

There is, of course, a fairly obvious downside to this; namely, the pension contributions are locked up until retirement and so they need to be seen as a ‘nice to have’ and not something that can add to your monthly salary.

What should you do?

As you will appreciate every person’s situation is different and the information above can only ever be taken as a general guide.

It is really important to make sure that you have individual advice before you make any hard and fast decisions regarding your method of payment.

Call us now and we can help you think about your own situation and how you can make it much more efficient.