Note: This article was published in April 2016. New allowances came into force on 6th April 2017. As such the information below is now outdated.
Liability aside, the vast majority of small business owners structure their business as a limited company for tax reasons. But with new measures on dividends introduced in April 2016 those tax advantages aren't as clear cut as they used to be.
One of the key questions owner/directors will be asking themselves is ‘what is the optimum level of pay this current tax year?‘ Well let's take a look:
In small one man businesses a director's pay is usually made up of two parts. One is the basic salary, the other is dividend pay. We'll start with the salary first.
Whilst there are many factors that come into play here, the basic principle is to ensure that any salary you withdraw remains less than the threshold for National Insurance contributions for both you as an employee and the business as an employer. For the 2016/17 tax year that's £670 per month (£8,040 per year).
Crucially, when taking at salary at this level you'll still earn a National Insurance credit/token, towards your state pension since your weekly salary will be over £112, but won't have to pay additional contributions.
It's important to note that the tax on dividends has now changed. From now on, the first £5,000 will be tax free. Added to that, any dividend pay up to the Personal Allowance is also tax free.
If you are maximising your tax advantage and drawing a salary of £8,040, that leaves £2,960 of Personal Allownece unused. Paying yourself dividends of this amount will then take you to the Personal Allowance limit of £11,000.
On top of that, you can pay yourself £5,000 in dividends completely tax free, leaving you with an income of £16,000, made up of a salary of £8,040, and dividends of £7,960.
The 7.5% dividend tax rate
Of course many shareholder/directors will want to reward their hard work with an income above £16,000. So here are the tax implications of drawing more dividends.
Any dividends paid over and above the unused personal allowance and dividend allowance, will be taxed at a flat rate of 7.5% up to a total income of £43,000. Compared to income tax at 20%, the 7.5% on dividends sounds great, but remember, the business will have probably paid corporation tax on it's profits to the tune of 20%.
Dividends in the higher tax band (over £43,000), will see a tax rate of 32.5%, and £38.5% for any dividends that take your income into the upper tax rate i.e. over £150,000.
Working it all out
Thankfully working out your take home pay is relatively straightforward. Let's say Fred has a business with a turnoever of £60,000 and costs of £5,000. He is the sole director and wants to extract all post tax profits as dividends. His pay might look like this:
minus £5,000 costs
minus £8,040 salary
£46,960 profit before tax
£37,568 profit after corporation tax (20%)
£45,608 gross pay (£8,040 salary + £37,568 dividends)
minus £848 tax on dividends at higher rate (£2,608 @ 32.5%)
minus £2025 tax on dividends at basic rate (£27,000 @ 7.5%)
£42,735 total take home pay (e.g. the cash in pocket)
Of course this calculation assumes that Fred is a UK resident for tax purposes, and doesn't have any other taxable income, or liabilities such as a student loan.
Now you may have noticed that Fred earns £2,608 in dividends that get taxed at a higher rate. There are a few things he could do to avoid this, such as pay into a pension. Alternatively if his wife has not used her dividend allowance, he could sell her shares in the business and pay her a dividend.
Of course this is only a rough calculation that makes some crude assumptions. This post is merely to get you thinking about directors' salaries, and excludes complications such as the Employers Allowance, for those who employ non-directors in the business.
How does this compare with being a sole trader? Well it we take a pre-tax income of £55,000 as an example, Fred would have a tax liability of £10,500 as a solve trader vs, £9,000 as a limited company. There's not much at this level, the real savings come when retaining profit in the business for later use.
For more in depth analysis, including take at look at John Falcon's post ‘Freelancer Contractor Take Home Pay Calculations 2016/17.'