Discovering that you are being investigated by HMRC can be very stressful, even if you are...
Most director shareholders want to ensure that they pay the combined lowest rate of tax possible when extracting money from their companies.
For many years, director shareholders have followed a high dividend low salary extraction strategy to pay themselves in the most tax-efficient manner.
The dividend changes that came into effect in April 2016 made the tax burden between a director taking the strategy above much closer to that of being a sole trader and being taxed as self-employed. The difference is now 3-5% difference when before it might have been 6-10% difference.
Before then, there was no further tax to pay on dividends received up to the higher rate tax band and the effective tax rate for higher rate taxpayers was 25% after a 10% credit was applied, which was a significant reduction on the higher rate tax and National Insurance Contributions (NIC) paid by employees around 42% in the higher tax band or 32% in the basic rate tax band.
There is currently an annual tax-free limit of £2,000 of dividends received (reduced from £5,000 in April 2018). Dividends drawn in excess of this amount are taxed at 7.5% in the basic rate band, 32.5% in the higher rate band or 38.1% above the higher rate band. In addition, dividends continue to be exempt from NIC. However, even with the new rules the strategy of taking dividends usually remains the most tax-efficient method of taking profits from your business.
It is important to remember that dividends can only be taken from retained profits within the company after tax has been calculated and paid. This means that if your company has no retained profits you cannot take dividends. If dividends are taken, Corporation Tax of 19% will also need to be paid - which can be avoided if salary is taken instead, although net salary taxes for owners through a limited company are higher than dividend taxes.
Interest on Director Loans
There are also other profit extraction options such as paying interest on any funds directors may have loaned their company. There is a £1,000 tax-free interest income allowance which not many people currently use up.
Tax Allowable Deductions
It may be assumed that any good accountant would have already used up all tax-free allowances and claiming for expenses. For example, making pension contributions is very tax efficient as long as it falls below the current annual allowance limit of £40,000 for tax-free contributions.
However, you will need to wait until you are at least 55 to access this money while you may have other more current plans to buy or invest. It is also important to remember that dividends don’t count as ‘relevant UK earnings’ for the purposes of tax relief on pension contributions. So if you pay yourself dividends then this may restrict the amount of tax relief available.
Director shareholders looking at implementing this high dividend low salary strategy should ensure that they take at least a minimum amount of salary at the national insurance primary threshold that will ensure sufficient contributions for a full minimum State Pension purposes. This is currently, as of 2020-21, £8,788 but in certain circumstances, a tax-efficient salary would be £9,500 per year.
Directors are classed as employees and pay NICs on annual income from salary and bonuses over £8,688 but also have an income tax free personal allowance of £12,500 below which no Income Tax is usually due. The actual amount to be taken should be decided based on the best fit for the company and the director. Therefore, advice should be sought from someone who knows the tax rules and your own personal circumstances. Contributions are calculated on an annual basis rather than from what they earn in each pay period but a payroll system will tax assuming a consistent pay will be charged across the tax year.
Most directors will be unable to live on such a low income and may have reason to pay themselves a higher salary and accept that their Income Tax bill will be higher. This can also help show adequate earnings if looking for a mortgage or looking to maximise health insurance policies.
The high dividend low salary strategy has caused issues for many directors as a result of the coronavirus pandemic. Since the furlough payments are based on a percentage of the gross salary, only, many director salaries have not been compensated enough to cover a lot of a directors’ total historic remuneration. This has been a big criticism of the furlough scheme itself.
Those who pay themselves a salary and dividends through their own company are not covered by the Self-Employed Income Support Scheme which is for self-employed individuals.