Decisions, decisions! Salary and dividends in 2019/20

Lee Sharpe crunches some numbers for combining salary and dividends in 2019/20.

In this article, I look at the basics of combining salary and dividends for owner-managed companies. I shall assume that the taxpayer is below state pension age and subject to National Insurance contributions (NICs) as normal, has no ‘other’ income of any substance, and adjustments for apprenticeships, student loans, etc., have been ignored – in other words, a standard ‘NIC Table A’ employee.

There are now different bands and rates for income tax in Scotland for ‘investment’ income (i.e. interest and dividends), but we are using ‘rest of UK’ rates and bands for 2019/20 below.

For the purposes of this article, ‘wages’ and ‘salary’ are used interchangeably – there is no tangible difference, from a tax perspective.

Salary and state pension entitlement

Entitlement to the state pension for employed earners requires that the individual be paid at a rate exceeding the primary threshold for the tax year in question. This threshold is actually set lower than the lower earnings limit, at which the individual earner starts to be liable actually to make primary contributions:

2019/20 Lower Earnings Limit £6,136

2019/20 Primary Threshold £8,632

The secondary threshold at which an employer starts to become liable for making employer contributions has been aligned with the primary threshold of £8,632. It is, therefore, possible to draw a salary of up to £8,632 for the year and not to trigger a liability for NICs but still ‘earn’ a credit towards state pension on retirement. This is equivalent to just under £720 a month – but note that paying exactly £720 a month would trigger a liability to NICs, albeit very small.

Example 1: Modest salary

Artyom is the sole director and shareholder of Metropolitan Travel Ltd. In 2019/20, he draws a salary of £8,400, or £700 a month.

This level of earnings exceeds the lower earnings limit so Artyom will ‘earn’ a credit for state pension entitlement for 2019/20. But it is just a little lower than the 2019/20 primary threshold (which is also now the secondary threshold for employers), so no NICs will actually be due.

Business tax relief

While salary or wages are essential for state pension purposes, they are also deductible for corporation tax purposes.

Dividends are paid out of the company’s residual profits after corporation tax – what is left over after everything else has been paid for. The company gets tax relief for salary and wage payments, but not for dividend payments.

Strictly, wages must still be paid ‘wholly and exclusively for the purposes of the business’, but in a family company this is generally problematic only if HMRC thinks a salary payment to a spouse, civil partner or close family member is excessive for the work done in return, and is really a payment to or for the benefit of the director/shareholder.

Example 2: Higher or lower?

Anna is the sole director and shareholder of Exodus Cruises Ltd, and also pays herself a salary of £700 a month, totalling £8,400 for the year.

With a standard PAYE tax code for 2019/20 of 1250L, she can earn up to £12,500 without having to pay any income tax, and her company will get tax relief for the salary paid to her.

If she draws a salary of £8,400, she will pay no NICs, her company will pay no NICs, there will be no PAYE income tax, and the company will reduce its corporation tax bill by £8,400 x 19% = £1,596.

So why pay dividends?

Dividends are still taxed relatively lightly where they fall in the basic rate band and are free of NICs. Let’s say that Artyom draws a dividend of £2,000 a month on top of his salary of £8,400:

	2019/20
		Tax Rate	£	£
			Income	Tax
Salary		0.0%	8,400	-
Dividend in rest of personal allowance		0.0%	4,100	-

Standard tax-free personal allowance			12,500

Balance of dividend:
‘Dividend allowance’		0.0%	2,000	-
Balance of Dividend		7.5%	17,900	1,343

Across his company and Artyom combined, he has managed to withdraw £31,057 after tax, etc., at a personal tax cost of £1,343.

To compare, let’s say that Anna takes a bonus of £24,000, on top of her original £8,400:

2019/20
	£	£	£	£	£
	Employer	Employer	Tax	Anna	Exodus Ltd
Salary plus bonus	32,400	32,400	32,400	32,400	(24,000)
Primary & secondary NI threshold; Personal allowance	(8,632)	(8,632)	(12,500)
	23,768	23,768	19,900
NIC rates/tax rate	12.0%	13.8%	20.00%
NIC costs/income tax cost	(2,852)	(3,280)	(3,980)	(6,832)	(3,280)

Anna gets net, in her hand				25,568
Extra cost to company of bonus					(27,280)
Corporation tax (saving at 19%)					5,183
At a combined cost of:
Employees’ NIC	2,852
Employers’ NIC	3,280
Income tax	6,832
Less: Corporation tax (saving)	(5,183)
Total	7,781

Anna has managed to withdraw only £25,568 after tax and NICs, at a cost of £7,781 across her and her company.

This includes the corporation tax saved only on the extra £24,000 in bonus, over and above the £8,400 salary paid already in both Artyom’s and Anna’s original scenarios.

In other words, paying the additional funds as salary instead of as dividends has cost Anna significantly more paid over to HM Treasury, and she has ended up with considerably less.

Marginal rates

The table below compares the marginal tax rates (i.e. the effective tax cost) of taking an extra £1 in bonus, or dividend, where the taxpayer is a basic rate, higher rate or additional rate taxpayer.

	Taxpayer is:
	Basic rate	Higher rate (£50k+)	Additional rate (£150k+)
Marginal tax rate
Bonus	40.25%	49.03%	53.43%
Dividend	26.00%	46.00%	50.58%

The biggest comparable saving is where the taxpayer is a basic rate taxpayer, i.e. earning under £50,000 a year. After that, savings are quite thin, but still leaning towards dividends.

Further considerations

Where dividends are more tax-efficient, a lower dividend may be taken than the gross salary required to achieve equivalent net incomes; but there are other income thresholds, etc., that need to be considered, such as:

Student loans (and now postgraduate loans);
High income child benefit clawback where adjusted net income exceeds £50,000;
Personal allowance threshold where adjusted net income exceeds £100,000;
Note that for the purposes of tapering the personal pension annual allowance, the income threshold includes all income, not just relevant earnings.

While these factors may cast dividends in a good light, salaries do not necessarily need to be paid out of distributable reserves, while such reserves are essential for dividend payments. And, of course, where there is more than one shareholder, a dividend of £x per share has to be distributed across all shareholders of that class, unless dividend waivers are implemented. Such waivers may, in turn, be subject to challenge by HMRC under the ‘settlements’ legislation (at ITTOIA 2005, s 624 et seq).

One point that HMRC occasionally pursues is whether or not the company would have had sufficient distributable reserves if no waivers had been implemented beforehand – arguing that the shareholder(s) who did receive a dividend could only do so because other shareholders gave up their right to a distribution, thereby constituting a settlement.

Conclusion

Dividends are generally advantageous when compared to a salary, particularly where they are taxed at only the basic rate. But salary is essential for earning NICs credits, and tax relief for the company. Striking a balance, particularly where earnings are near a threshold, where child benefit, losses, pensions, gift aid and/or student loans are concerned, can involve some expertise – check with your tax adviser regularly, to ensure you have the best ‘mix’.