29 November 2022
After recent tax announcements regarding income tax and corporation tax rate changes, it is worth revisiting the perennial question of how an individual should extract an income from an owner-managed company in the most cost-effective way.
Comparing the relative costs of extracting reward as dividends or salary (including bonuses) on or before 31 March 2023 and thereafter generates some interesting results in respect of both the method and timing of extraction. Before we look at those, let us remind ourselves of the tax treatment of the options available.
Owner-managers of a company generally have the choice whether to reward themselves via a salary/bonus or a dividend.
A salary, or bonus, is made as a payment for employment duties. Both are liable to employee and employer National Insurance contributions (NICs), and to income tax. The employer is entitled to deduct the payment, including the employer NICs, in calculating its taxable profits, provided that the payment made does not significantly exceed the market rate for the employment services provided.
Dividends can only be paid out of a company’s distributable profits. The recipient is taxed at lower rates of income tax than on most other types of income, but the company is not entitled to deduct dividend payments in calculating its taxable profits. This reflects the fact that dividends are an application of profits, whereas salaries are generally expenditure incurred to generate those profits.
Salary vs dividends – which is right for me?
The overall effective tax rate suffered on extracting salary or dividends from a company can be calculated by comparing the cost to the company with the net receipt by the shareholder. For example, if a company has £100,000 pre-tax profits and pays a dividend, it first needs to use some of the available funds to pay corporation tax on those profits. The balance can then be distributed to the shareholder, who would pay tax on the dividend received. The effective tax rate would be based on the combined tax paid by the company and the shareholder. This is illustrated in general terms in the table below.
The above figures are based on a company subject to the main rate of corporation tax with a 31 March year end paying a salary or a dividend out of profits earned in the same accounting period. A blended effective main rate of corporation tax applies for accounting periods straddling 31 March 2023 and hence the actual effective tax rates for such periods will vary from those set out above, as could those for dividends paid in a later year from earlier years’ profits, or profits of a year subject to the small profits rate or a marginal effective rate of corporation tax. Effective overall tax rates for dividends and salaries or bonuses paid between 1 April 2023 and 5 April 2023 may also vary as NICs and corporation tax rates for different tax years will apply.
As the table shows, other than for low salaries, which do not attract NICs, dividends are generally more appealing from a tax perspective due to the lower total tax payable. However, there are other considerations as well – for example, a salary can help build qualifying years towards a state pension, allow access to certain other state benefits and enable higher levels of personal pension contributions to benefit from tax relief.
How such amounts are received can also have an impact on the outcome of mortgage applications, and swapping salary for dividend will impact potential claims under critical illness insurance policies etc.
In practice, business owners often choose to reward themselves by a combination of both, with perhaps a salary sufficient to count towards state benefits and pension, topped up with dividends.
With the main rate of corporation tax rate increasing to 25% from 1 April 2023, the tax advantage of paying dividends over salary will reduce significantly in the new tax year. It will therefore generally make sense to extract any excess profits retained by owner-managed companies as dividends by 31 March 2023, but care will be required: accelerating such payments can push recipients into higher tax bands, increasing the overall tax cost considerably compared to if the same distribution were to be split across two or more tax years. Accelerating payments also accelerates tax payment dates, which may not be ideal. The answer, as so often, is to talk to your adviser in advance, and not to leave everything until the last minute.