Guide to Salary and Dividends
Most people have a figure in mind of how much they need to pay into their household each month.
Before deciding on salary and dividend some basic forecasting will help estimate how much profit the business will have available. Be careful it’s very easy to overestimate income and underestimate costs. Things to think about include:
- Estimate likely turnover - build in any affects of holidays, sickness, time between projects, etc.
- What capital might need to be introduced? - Equipment to be purchased, office rent deposits, other upfront costs, slush fund to cover delays on sales invoice payments. When will you get this money back?
- What direct business costs might there be? - Travel costs, accommodation, subsistence, etc.
- How much are the business overheads? – Computer software, stationery, bank charges, our fees, rent, rates, phone bills, internet, etc.
We’ll help you with all this type stuff as part of getting to know you; it's usually a good starting point for getting to grips with the business finances and helps with decisions on salary and dividends.
For companies, setting the directors' salaries is down to the directors and shareholders. There are tax benefits (but also potential risks with keeping salary low) we'd suggest thinking about the following:
- National insurance contributions - you’ll want to ensure that you're paying enough to be part of the national insurance scheme.
- Minimum wage – If you've an employment contract with your business then legally any salary must meet minimum wage for hours agreed in your employment contract.
- Personal income needs – How much do you and your family need each month to live on? Assessing your monthly outgoings is important when setting salary. We'd suggest a salary is at least enough to cover the contribution you make to the household each month; paying less tax overall is all well and good but practical living is also important. If you’re disciplined and have enough personal wealth to wait for your dividends then great - but if you start dipping into company money to top up a low salary then you risk HMRC assessing dividends as extra wages.
- Is the salary “commensurate” with the nature of the role? - What might someone expect to earn in your job role? A challenge on this point from HMRC is unlikely to be successful but setting an appropriate salary is often viewed from a moral or commercial standpoint rather than tax perspective.
- IR35 status (freelancers only) – Where there is uncertainty if IR35 applies, freelancers often decide paying a higher salary reduces the risk of investigation, or potential penalties and interest if a future decision goes against them.
Historically, tax planning for small businesses centred on declaring larger shared dividends and taking a lower salary; this reduced the amount of tax and NI payable. Two pieces of legislation (Income shifting and IR35 – see guides) have tried to stop this type of planning. It's worth understanding the basic principles:
Splitting share ownership (dividends) with a spouse – this resulted in the lower tax bands of both partners being used before any income would become taxable at the higher rate. Joint share ownership is no longer advisable because of Section 660 and income shifting legislation.
Avoiding NI payable on salary by paying more as dividend – There is no NI payable on dividends. The combined personal tax and corporation tax on dividends is higher than the income tax owed on salaries; however, the overall advantages of dividend often equates to around 11% of total overall income. IR35, where it applies, dictates how salary is calculated. The formula results in most of the business income (after expenses) being treated as salary rather that dividend and therefore full NI being paid.
If you’re a freelancer the decision whether your work is caught by IR35 should not be taken lightly. Please read our guide to IR35 and talk to us about your circumstances before making a decision.
If you decide that IR35 does apply then only a small proportion of income will be available as a dividend. It would then make sense to pay a higher monthly salary so that you have a more consistent income through the year. Bonuses would be paid on top as money built up in the business. A final bonus each tax year would be paid when the IR35 deemed salary is been calculated.
A sole trader or partnership will be free to take “drawings” at any time and will owe tax and NI each year on profits; dividends apply only to companies and there are rules over when and how much dividend can be paid.
Dividends are payments from post -tax profits made to shareholders in proportion to their share ownership. The decision to declare dividends is controlled by the directors.
Company profits are broadly calculated by adding up all of the company’s income, and then deducting the business costs, expenses and salaries paid out. Each year a company pays corporation tax on the profits it makes. The remaining amount is available for payment to shareholders as a dividend.
Directors don’t need to wait until the financial year to declare a dividend; however, they do need to check that enough profit is in the company to cover any dividend. We’ll help calculate the available profits from the company records.
Most shareholders prefer consistency; it is normal to pay dividends on regular dates, and often for fairly regular amounts – perhaps with the final dividend reflecting whether it has been a profitable year, money needed for investment, etc.
Companies generally do not declare dividends more than quarterly. With frequent dividends HMRC might consider they are not a return on investment at all but effectively extra salary. They would then be taxed accordingly under PAYE rule; dividend paperwork should always be properly completed to help avoid any debate. We can help with this if you like.
The UK tax year runs from 6th April to 5th April each year. Usually, salary payments will have had all tax and NI due already deducted by the employer. With dividends no income tax is in fact deducted, but corporation tax was paid on the company profits before the dividend was distributed. Historically government has kept the corporation tax rates for small businesses roughly the same as the basic tax rate. With a trend towards lower corporation tax rates, dividend taxes are rising to compensate.
Each year self-employed, directors and higher rate tax payers complete a self-assessment tax return. Any extra personal tax owed is due on the 31st January after the end of that tax year. The first £5,000 of dividend received each year is free of tax. As a basic rate taxpayer 7.5% of the dividend should be set aside for tax. Once total personal income (salaries, pensions, dividends, etc) in any tax year exceeds the higher rate threshold, the effective amount to keep by personally for the taxman is 32.5% of any further dividends declared.We're really keen to help you plan for personal tax so you avoid nasty surprises.