Being a company director means you can take a more flexible approach to how and when you pay yourself. In most cases this means taking a tax-efficient ‘split’ income, where part of the money you pay yourself from the company comes from a salary, and the other part comes from dividends. This tax efficiency is why some sole traders become limited companies.
The road to tax-efficient success essentially means taking advantage of any personal allowances and tax-free options. At the same time, you’ll also want to minimise Corporation Tax and avoid other company liabilities if at all possible (legally, of course).
What are the advantages of the split option?
There are some big considerations here, including:
- You can have some form of regular income as a salary, and then larger dividend payments to top it up.
- The salary part can be offset against the company’s Corporation Tax bill
- You’ll qualify for a state pension
- You don’t pay any National Insurance on dividends
And the disadvantages of the split option?
You should consider the following potential pitfalls too:
- You will need to run a PAYE scheme (which isn’t always straightforward)
- Paying out dividends means paperwork – even if you’re the sole owner and director!
- Whilst dividends aren’t subject to NI, they are subject to dividend tax (though there is a dividend tax allowance of £1,000 per tax year).
What taxes will a company director pay on their income?
Tax is inevitable, as the saying almost goes, so whichever way you pay yourself from your company, you’re likely to pay tax on it at some point.
What you’ll pay on the salary part
Just like any other employee, directors who take a salary are subject to income tax and National Insurance rules. These will be deducted at source (taken from your wages) by the ‘employer’ – in this case, your own limited company. You’ll report these and pay the deductions on to HMRC through PAYE.
The good news is that wages are a business expense. This means you can include them in your Company Tax Return, and offset your wages bill against Corporation Tax.
National Insurance Contributions (NIC) on PAYE for directors
Both employees and their employers must make Class 1 National Insurance Contributions where earnings reach the NI threshold.
This is why NI is so important for a company director, because in this case you’re both the employee, and the employer. To avoid paying two lots of NI on the same income, directors usually pay themselves a smaller salary which falls below the NI threshold.
Income Tax on PAYE
The Personal Allowance is the amount that you can earn before you start paying tax on it. For 2023/24, the personal tax-free allowance is £12,570. Anything you earn above this is taxed at the following rates (apart from dividend payments, which are taxed at a different rate):
- Basic rate – 20% (paid of earnings of £12,571 to £50,270)
- Higher rate – 40% (paid on earnings of £50,271 to £125,140)
- Additional rate – 45% (paid on earnings over £125,140)
Remember: If your adjusted net income exceeds £100,000, your Personal Allowance will go down by £1 for every £2 earned above that amount. So, in effect, if you draw a salary of more than £125,140 your personal tax-free allowance will be zero.
What taxes must be paid on dividends?
Directors will need to pay tax on any payments that exceed the Dividend Allowance of £1,000 a year. How much you’ll pay depends on the income bracket you fall under, but the good news is that rates are lower than they are for salaries and other income. You’ll need to work out your tax band by adding together all of your income for the tax year.
The dividend tax rate for 2023/24 is:
- Basic rate taxpayers– 8.75%
- Higher rate taxpayers – 33.75%
- Additional rate – 39.35%
Dividend payments are not classed as a business expense, unlike salaries. This means they can’t be deducted from the company’s Corporation Tax bill. As dividends are a proportion of the company’s profits, the company will have already paid Corporation Tax on that income before the dividend is paid out.
Is there a limit to how much can be taken in dividends?
Technically no, but it’s a good idea to only take what is necessary as a dividend, and leave anything else in the company as retained earnings. However, what you choose to take in dividends depends on unique financial circumstances (both yours and the company’s) and how much profit the company has made.
It’s also worth keeping in mind any other dividend payments you might be expecting. The £1,000 Dividend Allowance applies to all of the dividends that you receive in a year, not just from the company you run day-to-day. So, if you own shares in other companies, you might want to check how much of your tax-free allowance you’ve already used up.
What about directors’ loans?
A director’s loan is essentially any money that a director takes from a company that isn’t classed as a dividend, salary, or allowable business expense. The loans can also work the other way around; in other words, directors can lend money to the company to help with any cash flow issues or to buy extra equipment for example.
Directors’ loans can be a very useful tool for short-term, tax-free borrowing. However, there are strict rules about accounting for director’s loans, how long the loans can last, and how they should be repaid. If they aren’t paid back on time, then the money will be subject to tax.
How do allowable expenses work with salary and dividend payments?
There are quite a few allowable business expenses that company owners can make use of to reduce their tax bill.
We won’t go into every single claimable expense and benefit now because they’ll apply to each company differently, and frankly, we’d be here all day. However, as a guide, common allowable business expenses include:
- Travel expenses, meals, and entertainment costs
- Costs relating to training
- Retirement and pension benefits scheme payments
- Company cars
- Fuel expenses (mileage allowances) and parking charges
- Medical insurance
- Office equipment and computers
- Childcare costs
How the expense should be reported and taxed will depend on what it is. The Gov.uk website has a wealth of benefits and expenses information, along with applicable tax rates and rules. Don’t forget, you may also qualify for some income tax reliefs.
I’m interested in pension contributions specifically. How does that work?
As you may have now cottoned on to, paying yourself as a company director revolves largely around tax efficiency. So, as well as working out the optimum salary, another way of being tax efficient is to extract the profit from your business, and pay it into a pension fund.
When a director makes a contribution to a pension fund, that amount isn’t subject to Corporation Tax, NI, or Income Tax. However, it must fall below the annual allowance for tax-free pension contributions, currently set at £60,000.
Then there’s the Employment Allowance
The Employment Allowance means that employers can reduce their annual National Insurance Contributions by up to £5,000 each tax year. This is as long as their employers’ Class 1 National Insurance liabilities were no more than £100,000 in the year before.
Employment Allowance cannot be claimed by companies that have only one director who works alone. It can be claimed if there are two or more directors, or a single director and another employee. Being able to claim the Employment Allowance impacts the amount of salary a director can take to be tax efficient.