As well as being able to pay themselves as employees through PAYE, company owners/directors can draw dividends.
Furthermore, directors loans are available, as are a variety of employee expenses, all of which can go towards an overall ‘package’ of benefits.
But what is the most tax efficient way, using these various options, for company owners to pay themselves? Let’s first take a look at the types of taxation which apply to each of the different options.
What taxes need to be paid under PAYE?
Salaried directors will be taxed at source, through the Pay As You Earn (PAYE) system, just as any other employee. Income Tax and National Insurance Contributions (NICs) must be deducted, along with additional employer’s NICs, and paid to HMRC. Salary payments count as deductible business expenses and do not attract Corporation Tax.
Income Tax
In the tax year from 6 April 2020 to 5 April 2021, the standard Personal Allowance (i.e. the amount of income which can be earned tax-free) is £12,500. Beyond that, the income tax rates are as follows:
- £12,501 to £50,000 (Basic rate) – 20%
- £50,001 to £150,000 (Higher rate) – 40%
- Over £150,000 (Additional rate) – 45%
The latest rates of income tax can be viewed here.
National Insurance Contributions (NICs)
Aside from income tax, NICs must also be paid by both the employee and employer (so in the case of a company director/owner, they would be liable for both NICs). These are payable at a standard rate of 12% on earnings over £9,500 per year (known as the primary threshold) and up to £50,000 per year, at which point the rate is reduced to 2% for earnings in excess of this.
Additionally, the employer needs to top up NICs at a standard rate of 13.8% on weekly salary payments above £8,788 per year (known as the secondary threshold). The latest rates of NICs for both employees and employers can be viewed here.
What taxes are paid on dividends?
Directors who receive dividend payments are liable to pay income tax on any payment above £2,000. The rate of tax will depend on the individual’s income tax bracket. However, the tax rate applied to dividend payments is lower than the equivalents for salary payments, with the current rates as follows:
- £12,501 to £50,000 (Basic rate) – 7.5%
- £50,001 to £150,000 (Higher rate) – 32.5%
- Over £150,000 (Additional rate) – 38.1%
Unlike salaries, dividend payments do not count as business expenses and therefore cannot be deducted from the corporation tax bill. The latest dividend tax rates can be viewed here.
Please note: If dividends are taken, as well as having to pay dividend tax, corporation tax of 19% will also need to be paid (which can be avoided if salary is taken instead).
What taxes need to be paid on directors’ loans and expenses?
Directors’ loans over £10,000 and/or which are not repaid in full within 9 months attract the following taxes:
- Corporation tax – if the loan is over £10,000 and is not repaid within 9 months of the end of the relevant Corporation Tax accounting period.
- Personal tax – if the director’s loan is over £10,000.
Expenses come with different tax liabilities and some are tax free (e.g. certain childcare costs). A full list of expenses and benefits, along with the relevant tax rules and rates can be viewed at GOV.UK.
What is the most tax efficient way of paying myself?
The most tax efficient way for a company director to be paid is through a combination of salary (PAYE) and dividends. Further efficiencies can be gained by availing oneself of tax exemptions, and potentially by also using directors’ loans and expenses where necessary.
The key lies in taking advantage of any personal allowances and tax free options, whilst at the same time minimising corporation tax and avoiding other company liabilities where possible.
The most tax efficient approaches for company directors will vary depending on the specific circumstances and the tax rates and bands for the year, but the basic approach is as follows:
Step 1 – Salary
Multiple directors or companies with more than one employee
In companies with at least two employees, the directors can take a salary (PAYE) of £12,500 (or the current maximum level of personal allowance) and claim the Employment Allowance (see below). This approach will avoid income tax whilst at the same time enabling the sum paid to be deducted from company profits and therefore lower the corporation tax bill.
There will be a small amount of NIC which needs to be paid (since the personal allowance threshold is above the NIC thresholds) both on the employee and employer sides.
Sole directors with no other employees
In companies where there is a single director and no employees, the Employment Allowance cannot be claimed. Therefore, the most tax efficient approach (for the 2020/21 tax year) will be to take a salary at the primary threshold of £9,500 per annum. It should be noted that this will entail some administration in respect of payment of a small element of employer’s NICs.
An alternative method is to take a salary at the secondary threshold of £8,788 per annum; this will avoid NICs altogether and the ensuing administration, but is marginally less tax efficient.
Step 2 – Dividend payments
Draw dividend payments of at least £2,000. Beyond the tax-free dividend allowance of £2,000, it is best to only take what is necessary and leave the remainder in the business as retained earnings.
The tax paid on dividends will be lower than the tax paid on an equivalent salary; this is because the rates are lower than the corresponding income tax rates and there are no NICs to pay.
Although dividends cannot be declared as a business expense (whereas salaries can), the corporation tax which will need to be paid in addition to the dividend tax is still lower than the combined rates of income tax and NICs.
Step 3 – Expenses, directors’ loans, pensions etc
Expenses
There are a variety of allowable business expenses, and some company owners make substantial use of expenses and benefits, as an addition to salary and dividends. There are a whole variety of expenses and benefits which may be claimed by company directors, including but not limited to:
- Pension and retirement benefits schemes
- Computers and office equipment
- Training costs
- Company cars
- Fuel expenses (mileage allowances) and parking charges
- Medical insurance
- Travel expenses, meals and entertainment costs
- Childcare
There are different taxation and reporting rules depending on the type of expense. A full list of expenses and benefits, along with the relevant tax rules and rates can be viewed at GOV.UK.
Tax reliefs
Aside from business expenses, there are Income Tax reliefs, which consist of:
- Methods of paying less tax, to take into account money which has been spent on specific things; and
- Ways of reclaiming tax or getting it repaid in another way, such as into a personal pension
Although some of the tax reliefs are automatic, it is necessary to apply for others. Tax reliefs include:
- Pension contributions
- Charity donations
- Maintenance payments
Directors’ loans
A company director can make use of business funds for a limited time without paying any tax, through a director’s loan. However, strict time limits apply and if loans are not repaid on time, corporation tax and income tax will be levied.
Furthermore, it is not possible to simply keep making the same loan over and over again, as this is known as ‘bed and breakfasting’ and will attract tax.
Pensions
One of the most tax efficient ways of extracting profits from a business is to plough this into a pension fund. Making pension contributions avoids corporation tax, income tax and NICs, as long as it falls below the annual allowance for tax free contributions which is currently £40,000.
Furthermore, if money is taken out of the pension pot (when this is permitted – normally not before the age of 55), 25% of any amount taken is tax-free.
Employment Allowance
The Employment Allowance is a scheme which allows limited companies – whose employers’ Class 1 National Insurance liabilities were less than £100,000 in the previous tax year – to reduce their annual NICs by up to a maximum of £4,000 each tax year.
It cannot be claimed by companies which (i) have only one employee who is paid above the Class 1 National Insurance secondary threshold and (ii) if that employee is also a director of the company. In other words, it cannot be claimed by sole directors.
What this means in terms of tax efficiency is that sole directors with no other employees may want to consider taking a salary of no more than the primary or secondary thresholds (i.e. before NICs kick in), whereas multiple directors or those with other employees can take up to £12,500 (i.e. the maximum Personal Allowance) and then claim the Employment Allowance to offset NICs.
