If you operate through your own UK limited company you’ll often want to use the optimum tax planning strategy of extracting money from your company through a combination of dividends and a low salary.

This article outlines the most tax efficient salary and dividend structure for the 2017/18 tax year (6th April 2017 to 5th April 2018).

The Chancellor of the Exchequer has announced that the government will publish its next Spring Budget on Wednesday 8 March 2017 – although it is not expected that this will affect any of the guidance in this article,  we can’t be certain, and if it does we will update this article accordingly.

How are salary and dividends taxed?

All the guidance in this article assumes you are not a Scottish tax payer – this is because the Scottish parliament now has the power to set its own income tax rates, and for 2017/18 it has set a higher tax band of £43,000, which is lower than the rest of the UK’s higher tax band of £45,000.

Now, on to the details….

For the 2017/18 tax year the personal allowance is £11,500 – this means your first £11,500 of income is tax free.

If your only income was your company director salary then any additional salary above £11,500 would be taxed at 20%, and then once you hit the higher tax band of £45,000 any additional salary would be taxed at 40%.

There are further thresholds and tax issues to be aware of but we’ll keep it purposely simple for this article.

With regards to dividend income, from 6th April 2016 (the start of the 16/17 tax year) there were major changes made and a new dividend allowance was implemented.

For the 2017/18 tax year dividends are taxed as follows:

The dividend allowance means that an individuals first £5,000 of dividends are tax free.

Over and above this £5,000 the dividend income is taxed as follows:

• If you have any un-used personal allowance (£11,500 for 17-18) then that element is tax free
• Any dividends in the basic tax band (up to £45,000 for 17-18) attract a tax charge of 7.5%
• Dividends above the basic tax band (£45,000 for 17-18) are charged at 32.5%
• Additional rates of tax will apply at the upper tax band (£150,000 for 17-18)

It might help to look at a very simple example – imagine your only income was dividend income – you could receive £16,500 of tax free dividend income in 17-18. This is due to both your £11,500 personal allowance and also the £5,000 dividend allowance.

Tax efficient dividend and salary structure

For limited company contractors, freelancers and small business owners, taking a low basic salary with the balance of income being extracted as dividends is a common tax planning strategy.

The theory is as follows:

• You take a low tax efficient salary no higher than the personal allowance so that it does not attract personal tax
• You should make sure the salary is high enough for national insurance purposes i.e. that it counts as a years ‘stamp’ for your national insurance history to help protect your future entitlement to state pension and other benefits
• The salary is a tax allowable cost for your business so corporation tax is saved at 19% (corporation tax rate for 2017/18) on the gross (pre tax) salary
• Any additional amounts you extract from your company are treated as dividends which do not attract national insurance, therefore you are not paying any more national insurance than you need to be
• Please note that dividends are not treated as a tax allowable expense (unlike a salary) so your company does not save corporation tax on the dividends

Many people choose to limit their total income to not go into the higher tax band (£45k for 17/18) so they are not taxed at the higher levels of tax, but this will be a personal choice and a balance will need to be made between tax efficiency and how much of the available profits in your business you want to extract.

We must now assess what is the most tax efficient dividend and salary structure for 17/18.

What are the best levels of salary and dividends for 17-18?

The introduction of the Employment Allowance in April 2014 enabled employers to not pay the first £2,000 of employers national insurance. This then increased to £3,000 for 16/17 and 17/18.

Typically the employment allowance means that it is slightly more tax efficient to take a gross salary all the way to the tax free allowance level (£11,500 for 17-18), however HMRC announced that from 16/17 the Employment Allowance will not be available to companies where the only person on the payroll is a director, i.e. ‘single director employee’ limited companies.

Unfortunately what they have left open as a ‘grey’ area is the situation where there is a husband and wife who are both directors taking a salary with no other employees.

As things stand it would appear this would be ok, however it seems to be that HMRC’s intention is to block companies that have no ‘real’ employees from claiming the employment allowance (the government are trying to encourage small businesses to take on employees).

Our stand on this currently is to lean on the cautious side – in the situation of a husband and wife director payroll we would advise only claiming the employment allowance if both parties have an active role in the day to day business.

For typical contractors we would therefore advise not to claim the employment allowance and go with the simpler option outlined later in this article (Option 2).

If we get clearer guidance from HMRC we may change our position, however for now we are playing it safe and it also keeps things a bit simpler as you don’t need to pay any national insurance, as you will see later on.

With this in mind, we have outlined two different salary and dividend options which are put together on the basis that you wish to stay below the higher tax band (£45k).

We have made some key assumptions when preparing these calculations:

• You are a UK resident, but not a Scottish tax payer
• You have no student loan balance
• Your only income is your salary and dividends from your company
• You are not caught by IR35 (bear in mind the new public sector IR35 rules)
• You have a standard personal allowance
• Your company has sufficient post tax profits to support these dividends

Option 1 – claiming the employment allowance (if allowed), more tax efficient with a little more admin

Take an annual gross salary of £11,500 which is the standard tax free personal allowance for 17-18.

Your personal allowance may be a bit different if HMRC have adjusted your tax code but to keep it simple we’ll assume the standard £11,500.

This level of salary will not attract any personal income tax, but it will attract some Employees National Insurance which will total £400 (rounded).

No Employers National Insurance will need to be paid as it will be covered by the Employment Allowance, assuming you can claim it.

If you have other employees you will need to consider if their salaries already use up the £3k employment allowance, if they do then you would be better going for option 2 below.

With regards to dividends, the higher tax band is £45,000 so assuming you want to stay in the basic tax band this leaves you £33,500 of dividends to take.

There will be some personal tax to pay on these though, as the first £5k is tax free but after that they are charged at 7.5% tax.

See below table for illustration:

 

Any dividends taken above the higher tax band will be taxed at 32.5% and even higher if you trigger other tax tipping points such as the child benefit charge at £50k, £100k tax free allowance withdrawal and the upper tax band at £150k.

Option 2 – take a salary up to the NI primary threshold

If you can’t claim the employment allowance or want to keep things a little simpler this is a good strategy for you.

There are two National Insurance thresholds you need to be aware of:

• Lower Earnings Limit – as long as you earn above this you are protecting your entitlement to future state pension and benefits, without necessarily paying any National Insurance, leading us on to….
• Primary Threshold – if you earn above this you have to start paying National Insurance

So the sweet-spot is to go up to the Primary Threshold but no higher.

The National Insurance Primary Threshold for 17/18 is £157 per week or £8,164 for the year.

Therefore we would suggest a monthly Gross Salary of £680 which stays just below this threshold.

With regards to dividends, assuming as with Option 1 you wish to take dividends up to the higher tax band but no further, then you can take slightly more dividends with Option 2 than with Option 1.

This is because you are only taking just over £8k of salary which leaves approximately £3.3k of dividends that are in the tax free allowance, as well as the £5k tax free for the dividend allowance.

You are not paying any employees national insurance in this scenario which is why you end up with a bit more cash in your own pocket (at the expense of some additional corporation tax for your company).

The dividend tax calculation for Option 2 is :

Salary is £8,164 so this leaves £3,336 of dividends that can be taken tax free in the personal allowance (£11,500 less £8,164).

The next £5,000 of dividends are also tax free as they are within the dividend allowance. The leaves the balance of dividends of £28,500 taxed at 7.5% = £2,138 of tax.

See below for how this works out with regards to cash in pocket – it is the same tax amount as Option 1.

You will note that the net cash in pocket after income tax and employees NI is actually slightly higher in Option 2 than 1, by £401, however this doesn’t factor in the additional corporation tax you save on the higher Gross Salary in Option 1 .

See below comparison for a table which compares the two options side by side and considers the corporation tax effect as well.

Comparison

See below for a table which compares Options 1 and 2 and shows that overall Option 1 is more tax efficient by £234

 

 

For limited company contractors and freelancers, Option 2 is the recommended route and also has the added benefit of being able to get a bit more personal cash in pocket despite costing a little more corporation tax.

Option 2 also has the added benefit of being less admin intensive as no national insurance needs paying over to HMRC.