Thursday 15 October 2020

When the dividends don’t work


Most owner/directors of private limited companies will choose to pay themselves with a mix of salary and dividends.


Usually the most optimal set up is to pay themselves a salary up to the National Insurance Primary Threshold and top up the rest of their income as dividend.


In the current tax year (1920/21) that would mean drawing an annual salary of £9,500. Drawing a dividend of £40,500 in addition to the salary would give a gross income of £50,000. The income tax due on this would be only £2,287. No employee National Insurance would be due but a salary at this level would count as a qualifying year towards State Pension eligibility.


In comparison, personal income tax and employee National Insurance contributions on a £50,000 salary would be £12,358. Some £10,000 higher than the combined salary/dividend option.


The tax saving is much reduced if the combined company and personal tax impact are considered. Dividends are paid after corporation tax (unlike salaries they are not a tax deductible expense) so every £100 of dividend paid instead of salary incurs an extra £19 corporation tax. The company would also pay employers' National Insurance on salary above £8,632 per annum.


Nevertheless, for modest incomes, if looking purely on the basis of tax efficiency the combined salary/dividend option works best and most accountants will recommend this route.


So why wouldn’t an owner/director always choose this option?


There are a some cases where I think the salary/dividend route may not be the best choice:


    1. Where there are a number of senior managers who may not be shareholders


Where there are a number of senior managers who are not shareholders there might be a case for the owner drawing a ‘market rate’ salary for the contribution they make and topping up with dividends if profits are sufficient to allow this. This enables the owner to be transparent about profitability and remuneration with their senior management team. They might also combine this approach with a profit-based bonus scheme. The benefits may outweigh the tax savings gained from the salary/dividend remuneration method.


    2. Where an owner is preparing for exit


As above a ‘market rate’ salary reflecting the owner’s true contribution to the business might be a sensible transition in the years before they exit the business. The remuneration can be easily flexed if they gradually reduce their involvement. As with 1 above a top up dividend can be drawn on top of the salary if profits allow. This can be an added incentive for a business owner to drive the business to generate ‘surplus’ profits after allowing for their management contribution. In this way the business may be more likely to become a standalone investment rather than a lifestyle business.


    3. Where there are several shareholders with varying levels of input


Using salary rather than dividend in this case allows greater flexibility. As with 1 and 2 above dividends can be used as a ‘top up’ on the salary where all the shareholders benefit in proportion to their respective shareholdings.


There’s a saying in tax circles, ‘Don’t let the tax tail, wag the business dog’. 


I think it can apply here. 


It's not conventional wisdom for an accountant to say this but, in some cases, less tangible, business and operational considerations may sometimes override harder tax savings.


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