Have you ever wondered why your director’s salary such a strange amount? Why does it change each year and why isn’t it a nice round figure? Where do these odd figures come from? It’s all to do with one of the main advantages you have as a company director.
One of the benefits of having a limited company is that you get more flexibility around how you take your profit out of the company. A sole trader has no choice; the business profit forms part of their taxable income and that is what they are taxed on for both income tax and National Insurance Contributions (NIC) at year end. As a director and shareholder, things can be a bit different because you and the company are separate legal entities. The reason that many people chose to be a sole director and shareholder of a limited company, rather than a sole trader is that it allows you more options and control over the tax that is paid, particularly National Insurance Contributions (NIC).
With a limited company you have two ways to take the profit: via a salary and via dividends. A fixed salary normally forms the first slice of your income and then dividends can be used to make up the rest. There is a fundamental difference between salary and dividends. Salary is taken before tax and forms part of the company’s expenses whereas dividends are taken after tax.
Because the salary is taken before tax, like other expenses it reduces the amount of profit for the company and therefore reduces that amount of tax to be paid. So why not take a really big salary and pay less corporation tax? The reason is PAYE. Let’s assume that you want to take £24,000 per year in profit out of the company:
1. Salary of £24,000 per year (£2,000 per month).
What happens if all the profit is taken as a salary? Like any employee you are subject to PAYE which consists of both income tax and national insurance.
The current personal allowance for income tax is £10,600, so if you had no other income then you would have £13,400 of your salary over the allowance, that would be taxed at the basic rate of 20%, costing you £2,680 in tax.
In addition earnings over £8,060 per year are subject to Class 1 National Insurance at 12%. This would cost another £1,912.80 per year.
The limited company is also responsible for paying secondary (employer’s) NIC on earnings above £8,112 at 13.8% costing £2,192.24.
However for 2014-15 and 2015-16 there is an Employment Allowance (EA) covering the first £2,000 of employers NIC, so in this example there would be secondary (employer’s) NIC to pay of £192.24.
Corporation tax is due at 20% for small limited companies so if you took a salary of £24,000 per year you would save £4,800 per year in corporation tax.
Total PAYE costs with the EA would be £4,785.04 compared to £4,800 saved in Corporation tax, so you would save only a few pounds.
Without the EA the PAYE cost would be £6,785.34 compared to £4,800 saved in corporation tax and you would be £1,985.34 worse off. At higher salary levels the PAYE costs would outweigh the corporation tax saving even more.
2015-16: £14.96 better off (with EA)
2015-16: £1,985.34 worse off (no EA)
2. Salary of £10,600 (£883.33 per month)
So a high salary isn’t always a great option. But it seems a shame to waste the tax free personal allowance. Let’s see what happens when the salary is set at the current personal allowance level of £10,600.
Tax – £0 as this is at the threshold level for the personal allowance
Class 1 NIC is due at 12% on £2,540 (£10,600 – £8,060) which gives £304.80 due
Secondary (Employers) NIC is due at 13.8% on £2,488 (£10,600 – £8,112) which gives £343.34. With the EA this is reduced to zero.
Total PAYE costs are £304.80 compared to £2,120 saved in corporation tax. A difference of £1,815.20. Without the EA the difference would only be £648.14. This time round you are saving more money by paying yourself a lower salary.
2015-16: £1,815.20 better off (with EA).
2015-16: £648.14 better off (no EA)
3. Salary of £8,060 (£671 per month)
Finally let’s set the salary level at the NIC Primary Threshold of £8,060. This is the level at which no employers NIC contributions are due, but you will still get your NIC credits.
Tax £0 as below the personal allowance
Class 1 NIC is £0
Secondary (Employers NIC) is £0
EA does not make a difference as we are now below the threshold.
Total PAYE costs are £0 compared to £1,612 saved in corporation tax. A difference of £1,612.
2015-16: £1,612 better off.
Overall if the Employment Allowance is being used, the best saving is made by a salary of £883.33 per month to fully use your personal allowance. However although it saves the most money, the disadvantage of this salary is that there is will be Class 1 NIC due, with monthly PAYE payments of £25.40 to be made.
If you are happy to forgo a saving of £203.20 and take the salary level of £671 per month, you will still save £1,612 and you will not have the administration of making the monthly PAYE returns.
If you have employees who are not directors then it might be that your Employment Allowance is already being used up with their salaries. In which case the best saving you could make is £1,612 with the £671 per month salary.
But we said that you wanted to take £24,000 each year. If you only take a salary of £10,600 then what about the other £13,400?
This is where the dividends come in. Providing the company has enough profit left over after the corporation tax is paid then the remaining £13,400 can be paid as dividends.
Dividends come out of the company profits after tax so there is no additional tax to pay on them (unless you end up as a higher rate tax payer).
But salary comes every month and dividends are normally declared at year end. What happens if you can’t wait until that long?
Although dividends are generally declared at year end after tax, you can physically take the money during the year in the same way you take your monthly salary (see director’s loan article for how this works). However, remember that you can’t take more in dividends than the company can afford. If you do this and end up with an overdrawn director’s account there will be more tax due .
So am I better off overall?
So continuing with the same example, if you take £10,600 salary and £13,400 dividends it will cost you £304.80 in PAYE / NIC but you will save £2,120 in Corporation tax.
If the limited company earned £24,000 profit (not including the director’s salary), then taking a director’s salary of £10,600 would reducing the profit to £13,400. This would result in corporation tax of £2,680 and there would be £304.80 NIC, giving a total cost of £2,984.80. As a sole director and shareholder you would get £21,015.20 of the £24,000 after tax had been paid.
A sole trader earning £24,000 profit would pay £2,680 income tax, £145.60 in Class 2 NIC and £1,434.60 in Class 4 NIC. This gives a total cost of £4,260.20. The sole trader would only get £19,739.80 of their £24,000 profit after tax had been paid.
The limited company director would get an extra £1,275.40 of the profit for this example.
What’s the bad news?
The bad news is that limited companies have more costs associated with them so although you are saving money on one hand, you may be losing it on the other with potentially larger accountancy bills and more compliance returns to do. Whether the overall saving is worth the additional administrative overhead that comes with a limited company is something that it is worth discussion with your accountant and will depend on your particular circumstances and future plans.
Also, the figures shown here apply if you are a sole director and shareholder as a basic rate tax payer without additional personal income. Additional shareholders, higher profits and other sources of income all complicate matters and mean that your optimum salary versus dividends balance may be different. The good news is, that as a limited company, you do have some flexibility around this area and discussion with your accountant will help you to calculate the best option.
Because the thresholds change every year and allowances, such as the Employment Allowance, come and go, the optimum directors salary does not stay the same. Each year your accountant might have a different recommended amount, or you may need to make decisions such as PAYE admin versus potential savings.
There are also other options beyond the scope of this article, such as the company paying rent to the director for use of home as an office. Pension contributions can also be added into the salary mix if you want to take profits but don’t need them now. Again these options may be worth exploring with your accountant.