Dividends vs Salary In 2017/18

Sarah Bradford explores whether, for 2017/18, it is better to extract profits from a personal or family company as salary or dividends, or both.

Where a business is operated through a limited company (such as a personal or family company), to enjoy and use any profits personally, those profits must first be extracted from the company. When it comes to tax, all extraction methods are not equal. Also, as the tax landscape shifts, what worked well last year will not necessarily be the optimal strategy this year.

In formulating a tax-efficient profit strategy, it is first necessary to consider what level of profits needs to be extracted. If the profits are not needed outside the company, beyond a certain level it may be better to leave them where they are, rather than to extract them.

While there are a number of routes available for getting profits out of a company and into the hands of the directors, employees, and shareholders, when it comes to personal and family companies the top two contenders are dividends and salary. In this article, we will look at the various merits of each as a profit extraction route for the 2017/18 tax year.

There are advantages to paying at least a small salary, and conventional profit extraction wisdom suggests paying at least equal to the primary threshold for National Insurance contributions (NICs) purposes and extracting further profits as dividends. However, in certain circumstances it may be beneficial to pay a higher salary.

So, what is the optimal salary level for 2017/18, and what factors determine the optimal salary level?

For state pension purposes, a person reaching state pension age on or after 6 April 2016 needs 35 qualifying years to gain entitlement to a full single tier pension. Where a director or family member has not already built up 35 qualifying years and has no other means of making 2017/18 a qualifying year, paying a small salary can be beneficial from this perspective.

To make 2017/18 a qualifying year, the salary paid must be at least equal to the lower earnings limit for that year (set at £5,876). However, it is possible to acquire a qualifying year for zero contribution cost where the salary paid falls between the lower earnings limit and the primary threshold for NICs purposes. This is because, within this band, employee NICs are treated as having been paid at a zero rate. For 2017/18, this applies where the annual salary is between £5,876 (the lower earnings limit) and £8,164 (the primary threshold). The notional zero contributions payable on a salary at this level have the effect of making the year count as a qualifying year for state pension and contributory benefit purposes – hence the recipient gets a qualifying year for free.

For 2017/18, the primary and secondary thresholds are once again aligned. This means that on a salary of £8,164 or less, no employer contributions are payable either. 

The personal allowance is set at £11,500 for 2017/18. Where this has not been used up elsewhere, there will be no tax to pay on a salary of £8,164, as the salary will be sheltered by the personal allowance.

Profits extracted by way of salary are deductible in computing profits for corporation tax purposes (as is any associated employer’s NICs). 

A salary equal to the primary threshold of £8,164 for 2017/18 can be paid free of tax and NICs and has the added benefit of ensuring that 2017/18 is a qualifying year for state pension and contributory benefit purposes.

Depending on the circumstances, it may be tax-efficient to pay a salary above the level of the primary threshold.

Whether this is worthwhile will generally depend on whether or not the National Insurance employment allowance is available for 2017/18.

For 2017/18, the primary and second thresholds for NICs purposes are set at £8,164. Once the salary level goes above this level, employee and employer NICs are payable. For 2017/18, the main rate of employee Class 1 contributions is 12%, and the employer rate is 13.8%. 

As long as the personal allowance remains available, income tax does not come into the equation until the salary level tops £11,500.

In most cases, it is the availability or otherwise of the employment allowance that will determine whether the optimal salary level is at or above the primary threshold. The employment allowance will reduce the employer’s NICs bill by up to £3,000 a year. However, since 6 April 2016, the allowance has not been available to companies where the sole employee is also a director, as is usually the case for ‘one-man’ companies.

Although salary is deductible for corporation tax purposes, if the employment allowance is not available, once the salary exceeds the primary and secondary threshold, the combined employee and employer NICs cost outweighs the corporation tax deduction (at 19%, for the year starting on 1 April 2017). Therefore, in the absence of the employment allowance, the optimal salary level will be equal to the primary and secondary NICs thresholds of £8,164.

However, if the employment allowance is available to shelter employer’s NICs, once the salary level tops the primary threshold, it is only employee’s NICs which need to be taken into account until income tax kicks in once the personal allowance has been used up. Consequently, if the company can benefit from the employment allowance and it has not otherwise been used up, the optimal salary level is one equal to the personal allowance. The corporation tax deduction of £633.84 (i.e. 19% (£11,500 - £8,164)) on the salary in excess of the primary threshold exceeds the employee’s NICs of £400.32 (i.e. 12% (£11,500 - £8,164)) payable on additional salary. The same result is obtained if the director or employee is under 21, regardless of whether the employment allowance is available.

Is it worth going any higher? In a word, no; once the personal allowance has been used up, income tax will be payable on the salary, and this will outweigh any corporation tax deduction.

Dividends are paid out of post-tax profits and the funds used to pay dividends have already suffered corporation tax, which as mentioned for the financial year 2017 is at the rate of 19%. Dividends are less flexible than salary, as they can only be paid if the company has sufficient retained profits and must be paid in proportion to shareholdings – although this latter restriction can be overcome by the use of an ‘alphabet share’ structure.

The taxation of dividends was reformed from 6 April 2016. From that date, all taxpayers regardless of their marginal rate of tax receive a dividend allowance of £5,000 (for 2017/18). This is really a zero-rate band and dividends falling within this rate are tax-free, as they are taxed at a zero rate. However, dividends covered by the allowance count as part of band earnings. 

If the personal allowance has not been used in full (as may be the case if the employment allowance is not available and a salary is paid equal to the primary NIC threshold of £8,164, leaving £3,336 (i.e. £11,500 - £8,164) of the personal allowance to be set against other income), dividends sheltered by the remaining personal allowance will also be tax-free.

Once the dividend and personal allowances have been used up, dividends are taxed at 7.5% to the extent that they fall within the basic rate band, 32.5% to the extent they fall into the higher rate band, and at 38.1% to the extent that they fall within the additional rate band.

The combined effect of the personal and dividend allowance means that it is possible for each employee/director shareholder to extract profits of £16,500 (i.e. personal allowance of £11,500 plus dividend allowance of £5,000) free from income tax (although there may be some employee’s NICs and corporation tax to pay).

An effective strategy is to pay the optimal salary (either £8,164 or £11,500, depending on the availability of the employment allowance) and withdraw any remaining profits required for personal use as dividends. 

In a family company scenario, make use of each family member’s personal and dividend allowance first before paying further dividends that will trigger a tax liability, and then use up basic rate bands before triggering a higher rate liability. 

Further guidance on profit extraction can be found in the Tax Insider guide ‘Tax Efficient Ways to Extract Cash From Your Company’, which can be purchased through the Tax Report page on the Tax Insider website (www.taxinsider.co.uk).