February 10, 2016 What are the best Directors Salary and Dividend Levels for 2016/17 Question: “I am a contractor freelancer operating through a limited company and I use the low salary and dividend combination of extracting money from my company. In previous tax years I have made sure that I stayed below the higher tax threshold so that I didn’t have any income tax to pay on my dividends, however with the changes to how dividends are taxed from April 2016 with the introduction of the Dividend Allowance, I am unsure if this is still the best strategy. Can you advise what the best mix of salary and dividends is for the 2016/17 tax year i.e. from April 2016?” UPDATE – if you’re looking for 2017/18 salary and dividend guidance see our new article HERE – otherwise for 2016/17 guidance, read on…. Answer: The 2016/17 tax year has brought with it some major changes to how dividends are taxed which in turn has an effect on the optimum tax planning positions for directors who are also shareholders. The dividend changes from April 2016 have been covered by us in a previous article but we will outline the position again in this article. How dividend taxation worked before the 16/17 tax year There used to be something called the dividend tax credit which meant that from a personal tax perspective a dividend had to be looked at ‘gross’ whereas from the company that was paying the dividends perspective the dividend was seen as ‘net’. The dividend tax credit was 10% and an example of how this worked was: Company pays a cash dividend of £1,000 This is grossed up by 10% by calculating £1,000 divided by 0.9 = £1,111.11 It is the grossed up figure that is used for personal tax calculations. As long as your personal total income including gross dividend income was below the higher tax band (£42,385 for 15-16) then there was no personal tax to pay on your dividends. If you went over the higher tax band then the element of dividend in the higher tax band was taxed at 22.5% of the gross dividend (which was effectively 25% of the cash dividend). There were also additional tax rates at the upper rate of tax as well as other things that could affect personal tax including child benefit. How dividend taxation works from the 16/17 tax year (from 6th April 2016) The dividend tax credit has been scrapped, this makes it easier to understand in our opinion. A new dividend allowance has been introduced which 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 (£11,000 for 16-17) then that element is tax free Any dividends in the basic tax band (up to £43,000 for 16-17) attract a tax charge of 7.5% Dividends above the basic tax band are charged at 32.5% Additional rates of tax will apply at the upper tax band (£150,000 for 16-17) Optimal levels of salary and dividends for 16-17 Now we have explained how dividends will be taxed from 16-17 we need to look at what the most tax efficient levels of salary and dividends are. Taking a low basic salary with the balance of income being extracted as dividends is a common strategy amongst limited company contractors, freelancers and small business owners. The theory is as follows: Take a low salary no higher than the personal allowance so that it does not attract personal tax 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 benefits The salary is a tax deductible expense for your business so corporation tax is saved at 20% on the gross salary Additional money is extracted as dividends which does not attract national insurance therefore you are not paying any more national insurance than you need to be. Bear in mind that dividends are not a pre-tax expense for companies so you do not save corporation tax on dividends. The question is then, what is the optimal level of salary? The introduction of the Employment Allowance in April 2014 enabled employers to not pay the first £2,000 of employers national insurance. This is being increased to £3,000 for 16/17. Typically the employment allowance means that it is slightly more tax efficient to take a gross salary to the tax free allowance level (£11k for 16-17), however HMRC have 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 further in this article (Option 2). As we are specialist freelancer and contractor accountants this tends to be the option we recommend for most clients. We are hoping for clearer guidance to come from HMRC at which point we may change our position, however for now we are playing it safe and it also keeps things a bit simpler. 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 (£43k). We have made some key assumptions when preparing these calculations: No student loan balance Your only income is your salary and dividends from your company You are not caught by IR35 You have a standard personal allowance Your company has sufficient post tax profits to support these dividends Option 1 – claim the employment allowance (if allowed), more tax efficient with a little more admin Take an annual gross salary of £11,000 which is the standard tax free personal allowance for 16-17. 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 £11,000. This level of salary will not attract any personal income tax, but it will attract some Employees National Insurance which will total £355.20. No Employers National Insurance will need to be paid as it will be covered by the Employment Allowance. 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 £43,000 so assuming you want to stay in the basic tax band this leaves you £32,000 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 is 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 16/17 remains the same as 15/16 at £155 per week or £8,060 for the year. Therefore we would suggest a monthly Gross Salary of £670 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 almost £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 £8,040 so this leaves £2,960 of dividends that can be taken tax free in the personal allowance (£11,000 less £8,040). The next £5,000 of dividends are also tax free as they are within the dividend allowance. The leaves the balance of dividends of £27,000 (£34,960 less £2,960 less £5,000) taxed at 7.5% = £2,025 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 £355, however this doesn’t factor in the additional corporation tax you save on the higher Gross Salary in Option 1 . See below summary section 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 £237 For 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 NI needs paying over to HMRC. Tax planning ideas Here are some tax planning ideas you might want to consider to help reduce the impact of the dividend tax changes, these should be discussed with your accountant: Transfer a minority shareholding to your spouse so they can receive up to £5k of dividend tax free Set up a rental agreement with your company for claiming ‘use of home as office’ expenses Company pension contributions (speak to a pension advisor as various rules to consider) We hope you have found this article about optimum salary and dividend levels for the 16/17 tax year useful.