The average employee has little say in how and when he is paid. Most employees are paid weekly or monthly and tax and Class 1 National Insurance is deducted at source from their pay. The employer pays this, together with the employer’s National Insurance, over to HMRC and that is that.
The shareholder-director has the luxury of choice meaning that some tax and National Insurance costs are optional.
In the main, the remuneration menu offers the choice of paying a salary, bonuses and dividends or a combination of all three. As one would expect, each has its advantages and disadvantages, the key ones of which are summarised in the table below.
|Type of Payment||Advantages||Disadvantages|
• Provides a regular income;
• High National Insurance cost to both employer and employee (employer-13.8%; employee 12% main rate and 2% additional rate);
• Flexible as to timing and amount;
• High National Insurance cost, particularly for employer;
• Employer must operate PAYE so added compliance cost.
• No National Insurance – considerable NIC savings;
• Not deductible in computing taxable profits of company;
An Effective Compromise
As noted in the table above, there are advantaged and disadvantages in relation to each. As is often the case, a compromise frequently offers the best solution.
In the ‘dividend versus salary or bonus’ debate, the most effective route depends on the rate of corporation tax paid by the company, the taxpayer’s marginal rate of income tax and the rate of NIC payable by the employer and the employee.
In the salary/bonus route the director pays tax at his or her marginal rate of tax and also National Insurance at the main rate of 12% up to the upper earnings limit and at 2% thereafter. The employer must deal with PAYE and pay employer contributions at 13.8%. However, the costs are deductible in computing the taxable profits of the company, saving 20% for a company paying tax at the small profits rate. Paying National Insurance contributions preserves the director’s contribution record.
By contrast, there is no National Insurance to pay on a dividend (resulting in combined NIC savings of up to 25.8%). Further, the tax liability for dividends is matched by the associated tax credit up to the basic rate limit, meaning no actual tax is payable until this limit is reached (total income above £42,475 for 2011/12).
However, there is no deduction in computing company profits. Dividends can only be paid if there are sufficient retained profits and must be paid in accordance with shareholdings.
In most cases the most effective strategy (profits permitting) is to pay a small salary of between £442 and £589 per month as this will preserve the employee’s contribution record for zero contribution cost on the part of the employee or employer. This is because notional contributions at a zero rate are payable by the employee between the lower earnings limit and primary threshold. At this level no PAYE is generally due.
Beyond this, provided that the company has sufficient retained profits it is generally efficient to extract profits by way of dividends.
However, there is no substitute for crunching the numbers to take account of individual circumstances and it is advisable that professional advice is sought.
When fixing the level of the salary set it below the (lower) secondary threshold to avoid having to pay and account for employer’s NICs.
By Sarah Bradford