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In this first part of this article, we considered the question:

“Many business owners ask “Would I be better off as a Limited Company?” or if already trading via a Limited Company the opposite question, “Would I be better off as a Sole Trader/Partnership?” in the context of various changes to the tax regime recently, notably changes in NI rates and the graduated Corporation Tax regime.

In the second part of this article we are looking at how these various tax changes play out for existing companies, and their shareholders and directors.   We are assuming here smaller owner managed businesses where the directors and shareholders are the same.

 

What is the Issue Here?

How profits are extracted from a small company can vary the resultant tax liabilities considerably.  For the most part the choice is directors salary v shareholders dividend.

It used to be that in almost all cases a small salary and take the rest as dividend yielded the best results.  The issue is that changes in recent years, notably with NI going down and Corporation Tax going up, the position has potentially changed.

 

What are the Variables and Issues?

This is best examined by considering a notional £10,000 of profit to be extracted from a small company, and the choice of salary or dividend.

A salary is subject to Income Tax in the hands of its recipient, a dividend to Dividend Tax.   Income Tax, on a salary, is charged at 20%, 40% or 45% depending on income band.  Dividends are taxed at 8.75%, 33.75% or 39.35% on the same income bands – but a salary gives the paying company a deduction against Corporation Tax, whereas a dividend is taxed after the company has paid Corporation Tax.

Example 1 on the notional £10,000, and assuming a Corporation Tax rate of 19% and the Higher Rate personal tax band:

  • on a salary, £4,000 of Income Tax is due and £0 of Corporation Tax – the calculation is £10,000 x 40%.  £6,000 is left after taxes.
  • on a dividend, £1,900 of Corporation Tax is due and £2,734 of Dividend Tax, total £4,634 leaving £5,366 after taxes

Example 2 – as above but the Corporation Tax rate is 25%

  • on a salary, £4,000 of Income Tax is due and £0 of Corporation Tax – the calculation is £10,000 x 40%.  £6,000 is left after taxes.
  • on a dividend, £2,500 of Corporation Tax is due and £2,531 of Dividend Tax, total £5,031 leaving £4,969 after taxes

So, on the face of it easy decision – salary.

However salaries are also subject to National Insurance, Dividends are not.  There are two types of NI:

  • Employers NI, paid by the employer (the company in this case) for which the main rate is 13.8%, but the employer gets Corporation Tax relief on this
  • Employees NI paid by the recipient – the main rate is 8%

Note there is a starting threshold at 0% for both, and whilst Employers NI is not capped, there is a cap on the main rate of Employees NI, after which it drops to 2%

Example 3 – Returning to example 1 above, Corporation Tax rate 19%, and factoring in Employers and Employees NI:

  • £10,000 of profit allowing for Employers NI and Corporation Tax Relief grosses down to a salary of £8,995.  Total taxes are Income Tax £3,598, Employees NI £720, Employees NI after Corporation Tax relief £1,005.  Total taxes £5,323, leaving £4,677 net after tax
  • on a dividend, £1,900 of Corporation Tax is due and £2,734 of Dividend Tax, total £4,634 leaving £5,366 after taxes

Example 4 – Returning to example 2 with a Corporation Tax rate of 25%:

  • £10,000 of profit allowing for Employers NI and Corporation Tax Relief grosses down to a salary of £9,062 (higher than example 3 as Corporation Tax relief on Employers NI is higher) .  Total taxes are Income Tax £3,625, Employees NI £725, Employees NI after Corporation Tax relief £938.  Total taxes £5,288, leaving £4,712 net after tax
  • on a dividend, £2,500 of Corporation Tax is due and £2,531 of Dividend Tax, total £5,031 leaving £4,969 after taxes

This has swung the position back to favouring dividends.

You start to see some of the considerations.  However there are many other factors to bear in mind:

  • Corporation Tax rate – which varies with profit.  Broadly profits up to £50,000 are taxed at 19%, profits of £50,000 to £250,000 are taxed at 26.5% (due to the tapering of the 19% rate), profits over £250,000 are taxed at 25%.  Salaries are a deduction against profit for Corporation Tax, so they both reduce the amount of profit charged to Corporation Tax and the blended Corporation Tax rate, whereas dividends are a post tax distribution of profits, which are computed after Corporation Tax is provided for.
  • Thresholds and starting rates – for Income Tax everyone has a £12,570 Personal Allowance where no Income Tax is charged, but this is tapered out where personal income exceeds £100,000, creating a 60% marginal rate.  There is also a Dividend Allowance of £500 for tax free dividends.  Both Employees and Employers NI have starting thresholds working in a similar way – £12,570 for Employees NI and £9,100 for Employers NI.
  • Aggregation of taxes – Income Tax is aggregated on all sources, and Dividend Tax is charged normally at the highest level of Income Tax banding.  By contrast NI is charged separately on a source by source basis.
  • Employer NI Allowance – this only applies where there are two directors in the company (or a director and another employee) and rebates up to £5,000 of Employers NI – meaning on that element of salary only employees NI is due.
  • Directors other income, e.g. rental income.
  • Whether shareholdings are 50:50 or are skewed.

It can be seen there are a number of variables to consider; and don’t worry if they aren’t all clear, tax is alas not straight forward and that is why businesses engage accountants.  Thankfully the variables can be modelled.

 

What the Modelling Shows

We’ve run models for profits – before salaries, but after all other expenses – up to £300,000 and for salaries up to £100,000.  These cover all potential permutations, as over those levels whilst the quantum of tax will increase, the variable factors won’t change.  All the figures below are annualised and 2024/25 tax rates as of June 2024, pre General Election.

For a company with a single director / shareholder our modelling shows that at all profit levels the most beneficial salary is £12,000 – probably it is £12,570, but the rounding won’t make much of a difference.  For tax it’s optimal to distribute the remainder as dividend.  £12,000 is a fairly common salary level already.

For the single director / shareholder with other income, say rents, of £10,000 a year then the most beneficial salary is £10,000, but the difference to £12,000 a year is negligible – on most scenarios under £50 a year – so if you are already taking £12k is probably not worth a change.

Where there are two directors / shareholders, due to the Employment Allowance, the position is more nuanced.  If the directors / shareholders have no other income then:

  • Generally the optimum salary level is £14,000, paid to both officers, dividend for the remainder
  • If profits are in the zone of £90,000 to £100,000 – and we have only modelled in £10k steps – then the optimum salary increases progressively to £24k, again paid to both officers, dividend for the remainder.  This higher salary could save up to £1,000.
  • Over £100,000 the optimum returns to £14,000

We also modelled these scenarios with the directors / shareholders having other income of £10,000 each, and whilst the quantum of tax is higher, the optimal salaries don’t change.

Finally for two director / shareholder scenarios, we looked at situations where one director is salaried at, say, £12k and another at, say, £8k – a common arrangement if one director is less active in the business.  For the most part its optimal if both have the same salary – saves £800 or so a year at most levels.

A couple of caveats on the two director / shareholder scenarios:

  • We modelled salary in £2k bands up to £50k, and thereafter £10k bands. In many cases for the two director / shareholder position the optimum salary may be between the bands.  This won’t have a huge effect, eg profits £90k and no other income, the optimum salary is £20k, however a salary of £18k results in only £200 more being paid, whilst a salary of £22k results in £80 more being paid – so the fine tuning is not that sensitive.
  • Profits were modelled in £10k bands up to £100k and thereafter £25k bands.  In between the bands there will be different optimums, but again the differences won’t be great.

More generally, caveats applying to all these models:

  • Personal circumstances differ e.g. second employment, rental income etc, and planning needs to be individualised.
  • The tax and fiscal environment can change – at the time of writing a General Election campaign is under way and we will almost certainly have further changes in a mini budget later this year.
  • Profit levels can, of course, not always be planned precisely so best guess of profits is needed in setting the salary level.  As the paragraph above explains, going slightly up or down on the salary won’t impact greatly.

 

Takeaways

So what are the takeaways from this?

  • In most cases a salary of £12k to £14k is going to be optimal.
  • Subject to wider considerations, eg Income Shifting rules for unmarried couples, and overall family asset mix, equalising salaries and shareholdings is sensible.
  • Although there are some savings to be made where profits are in the £80k to £100k zone and two people are involved in the business, in most cases recent changes to NI and Corporation Tax haven’t changed the approach to salary and dividend mix.

These thoughts need to be contextualised in a wider scenario of business and family planing, eg:

  • Estate planning.
  • Planning of joint finances for unmarried couples.
  • Asset protection.
  • Income Shifting – largely only an issue for unmarried couples.
  • PEST – Political, Economic, Social and Technological change – especially relevant with a likely change of Government.