Most owner managers of a business will be told at some point by their accountants that they should pay themselves a ‘tax efficient salary’ and then draw the rest of their income as dividends. What does this mean, and what is the best way to achieve ‘tax efficiency’?
The Basic Salary
Salaries for company owner managers are normally set at one of three amounts:
- The Secondary NI threshold (£8,788 per year in 2020/21)
- The Primary NI threshold (£9,500 per year in 2020/21)
- The PAYE tax personal allowance limit (£12,500 in 2020/21 for most taxpayers)
Which one is most appropriate depends on the particular circumstances of the company, the individual, and to some extent personal preference.
It is important for an owner director of a company to be on a properly set up company payroll (unless they have another source of earned income). It is possible, if there are no other employees, to pay a salary of up to £6,239 per annum (2020/21) without reporting this to HMRC through a PAYE scheme. However this will not give them any credits towards their state pension, and so should generally be avoided.
Secondary NI Threshold
All salaries paid by a company are tax deductible for that company; thus by paying a salary to a director a company will make corporation tax savings of 19% of the cost of the salary (at 2020/2021 rates). Salaries of £8,788 per year also attract no employer’s or employee’s NI charge (while still giving NI credits to the director), and are below the personal allowance of most individuals, making a salary at this level a very attractive option.
Primary NI Threshold
A salary of £9,500 per annum will be subject to employer’s NI of 13.8% on the amount above £8,788. However this is less than the 19% corporation tax which would be charged on this amount if not deducted from the profits as salary, and significantly less if the cost of drawing the equivalent amount as dividends (an additional 7.5% of personal tax charge) is taken into consideration.
In addition, for some companies there may be no employer’s NI cost. This would be the case where there are other employees (earning over £6,240 per year), but the employment allowance of £4,000 (2020/21), which is an allowance against the cost of employers NI, is not fully used by the other employees.
Despite the tax savings of paying a salary at this level, for some directors the hassle of paying yet another tax to HMRC outweighs any tax savings they would make. In these cases, a salary at the Secondary NI threshold is more appropriate, as this takes away any PAYE costs. In addition, if a company has corporation tax losses, they may prefer not to incur a tax charge when it may be some time before the benefits from this are realised.
Using the full personal allowance
A salary that makes use of the full personal allowance for income tax (£12,500 in 2020/21) will be subject to both employer’s NI (ignoring any employment allowance potentially available) and employee’s NI costs. Salary above £9,500 will be subject to both employee’s NI of 12% and employer’s NI of 13.8%, bringing the total tax cost of that element of salary to 25.8%. However it must be remembered that this salary is tax deductible for corporation tax, bringing a tax saving of 19%. Employer’s NI is also tax deductible – this brings about a saving of 2.622% on the part of salary subject to employer’s NI. Finally by paying salary no dividend tax is due, saving an additional 7.5% personal tax.
Thus for comparison, if we look at the tax ultimately paid after tax reliefs are taken into account:
- Paying dividends instead of salary for income of between between £9,500 and £12,500 costs dividend tax of 7.5%, giving a total additional tax charge of £225
- Paying salary at income levels between £9,500 and £12,500 costs 25.8% in NI, less corporation tax relief of 19%, less Corporation tax relief on the employer’s NI of 2.622% (of the income). So the total tax cost is only 4.178%, or £125.34
So in most cases a salary of £12,500 is most tax efficient for the owner / director.
However there are cases where this analysis may not be appropriate:
- If the company is loss making
- If the director has another source of taxable income or receives benefits in kind
There is ‘no one size fits all’ amount that should be paid to owner managers – if you aren’t sure that the salary level that has been set set is right for you, or makes the best use of your allowances, do discuss this with your accountant, or contact us for further information.