When a limited company is formed a new entity is created. Legally this entity is separate from all other persons including the owners (shareholders) who may or may not be the same people as those who manage the company (directors).
As such, it must be remembered that the income deposited into the company’s bank account belongs solely to the company; no-one has the automatic right to withdraw monies as and when they please – a concept that many new shareholder/directors find difficult to grasp! Nevertheless, shareholders are entitled to receive some payment and so long as the correct procedure is followed, confirmed by the correct paperwork, then effective tax savings can be achieved - even in these difficult times.
There is a choice of methods available for the extraction of monies from the company, which one to use that will result in the minimal amount of tax being paid both by the company and the shareholder/director is dependent upon individual circumstances. As James Bailey stated in his article ‘Extracting Cash from our Company - other Entities - May 2013’ ”the difficulty with a company is how to get the cash out ... once corporation tax has been paid.”
Assuming that the director is also a shareholder, then the two most effective methods for the saving of tax both from the view of the company itself and the director is via the use of salary and/or dividend. Flexibility is the key here and the following are some points to consider:
•A salary payment is a set amount paid by the company normally through the PAYE tax system. The actual amount paid will depend upon whether the director is an office holder only or also works in the business. If solely an office holder, there is no obligation on the company to make any payment whatsoever as there is no contract of employment; any payment will be at the discretion of the directors. In contrast, a director who is also a worker must legally be paid at least the national minimum wage as they will be subject to a contract of employment.
•If under contract the company must register as an employer with HMRC and run a PAYE scheme, to include the completion of end of year returns. This is the situation even if there is a sole director who works for the company.
•The cost of a salary including any National Insurance contributions (NIC) is treated as an expense for corporation tax purposes in the company’s books, thereby generally reducing the company’s corporation tax bill
•Salaries can be paid even if the company has made a loss for the year.
•The personal allowance to which all taxpayers are entitled is first offset against any payment received as salary with any additional amount being taxed at the basic rate of tax.
•Dividends are effectively a reward given to shareholders for taking the risk of investing in the company.
•The most valuable and beneficial reason for dividends to be paid in preference to a salary is that dividends are not liable to NIC either by the company or the shareholder – this reason alone can result in significant savings.
•The payment of salary is as agreed in the employment contract; in comparison it is the directors who decide if, when and how much to pay the shareholders. Dividends can be paid more than once a year; ideally quarterly, but monthly is also possible.
•When the dividend is paid a tax credit of 10% is allocated to the payment which is a notional amount. The company benefits as no tax is paid on the payment made and the shareholder benefits as no further tax is paid unless they are a taxpayer who pays tax at the higher or additional rates of tax.
•HMRC may query a large payment made as a salary or bonus under a ‘commercial reality test’ asking detailed questions as to the viability of the company; dividends are never subjected to such tests.
•A dividend is paid from profits made by the company; therefore, if no profit has been made over a given period or there are no undistributed profits brought forward from previous years, no dividend can generally be paid.
•Paying a dividend does not reduce the company’s tax liability because the company’s taxable profit on which tax is calculated does not take the dividend into account.
•An ordinary dividend must be paid to all shareholders of the company. It cannot be paid to just one shareholder in preference to another or be paid at a different rate. If this proves to be a problem it can be possible to waive dividends (see article ‘Dividends (3) - Tax Planning Using Dividend Waivers’ - March 2013 issue) or possibly create new classes of shares.
•Certain rules must be followed when a dividend is paid, such as to not make the payment an ‘illegal distribution’ of profit but the rules are not difficult to follow (see article ‘Dividends (Part 2) - How to Ensure that the Payment is Legal’- February 2013 issue).
How much to pay as a salary?
Three options need to be considered:
1.Salary below NIC lower earnings limit (LEL)
The LEL is the amount that can be withdrawn from the company before NIC is paid, which for the tax year 2013/14 is £109 per week. The company does not need to register with HMRC as being an employer, does not need to run a payroll system nor complete the employer annual returns. However no NIC credits are allowed towards the state pension and some other state benefits.
2.Salary equal to the NIC LEL
This is the amount that can be withdrawn before NIC must be paid; no tax or NIC is actually due BUT NIC credits are allowed towards the state pension and some other state benefits. However, the company will need to register as an employer, run a payroll system operating the scheme under the new Real Time. Employers who have to operate PAYE for at least one employee will have to report PAYE information in Real Time.
3.Salary above the LEL
Any payment made in excess of the LEL will generally require both tax and NIC to be paid. Again, the company will need to register as an employer, run a payroll system and complete the employer annual returns.
How much to pay as a dividend?
No personal allowance is allocated (as for salary) against the dividend payment. The maximum amount that can be paid is not subject to restriction other than being limited to the amount of profit made by the company. However, should the money be subject to a higher or additional rate tax charge, consideration is needed as to whether to retain the monies within the company to be withdrawn at a later year when the director’s tax rate might not be so high, or withdraw via other methods.
Practical Tip :
The ideal is to have the best of both worlds – namely to withdraw the LEL amount in salary thereby ensuring that particular year counts towards the number of years needed for state benefits with the remaining payment taken as dividend. This has the benefit of not producing a tax bill on the amount withdrawn for either the company or the shareholder and there is the additional benefit of a 10% tax credit being allocated to the dividend payment.