January 9, 2018 Optimum Directors Salary & Tax on Dividends 2018/19 If you operate through your own UK limited company as a freelancer, contractor or even as a small business owner, you’ll often want to use the tax planning strategy of extracting money from your company through a combination of dividends and a low salary to ensure you optimise your tax on dividends. This article outlines the most tax efficient way to pay yourself with salary and dividends for the 2018/19 tax year (6th April 2018 to 5th April 2019) and it also explains how dividends are taxed. UPDATE: If you’re looking for advice with regards to the 2020/21 tax year please see our newer article: Optimum Salary and Dividends 2020/21 How are salary and dividends taxed? For the 2018/19 tax year the personal allowance is £11,850 – this means your first £11,850 of income is tax free – this is an increase of £350 from the 2017/18 personal allowance which was £11,500. If your only income was your salary then any additional salary above £11,850 would be taxed at 20%, and then once you hit the higher tax band of £46,350 any additional salary would be taxed at 40%. Scottish tax payers actually have a lower higher tax band than this, as well as some other income tax thresholds, however for the purposes of dividend taxation, which is what this article is about, the higher tax band is the same as for the rest of the UK, at £46,350. There are further thresholds and tax issues to be aware of but we’ll keep it simple for this article. With regards to dividend income, the tax free dividend allowance for 16/17 and 17/18 was £5,000 – however for 18/19 the dividend allowance has been reduced to £2,000. For the 2018/19 tax year, the tax on dividends is as follows: The new lower dividend allowance means that an individual’s first £2,000 of dividends are tax free. Over and above this £2,000 the dividend income is taxed as follows: If you have any un-used personal allowance (£11,850 for 18-19) then that element is tax free Any dividends in the basic tax band (up to £46,350 for 18-19) attract a tax charge of 7.5% Dividends above the basic tax band (over £46,350) are charged at 32.5% Any dividends in the upper tax band (£150,000 for 18-19) are taxed at 38.1%. It might help to look at a very simple example – imagine your only income was dividend income – you could receive £13,850 of tax free dividend income in 18-19. This is due to both your £11,850 personal allowance and also the £2,000 dividend allowance. Most 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 2018/19) on the gross (pre tax) salary Any additional amounts you extract from your company (apart from expenses) 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 (£46,350 for 18/19) 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 18/19. What is the optimum level of salary and dividends for 2018/19? 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, 17/18 and 18/19. Typically the employment allowance means that it is slightly more tax efficient to take a gross salary all the way to the tax free personal allowance level (£11,850 for 18-19), however HMRC announced that from 16/17 the Employment Allowance would 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 (£46,350). We have made some key assumptions when preparing these calculations: You are a UK resident 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 but a little more admin Take an annual gross salary of £11,850 which is the standard tax free personal allowance for 2018/19. 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 £11,850. This level of salary will not attract any personal income tax, but it will attract some Employees National Insurance which will total £411 (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 £3,000 employment allowance, if they do then you would be better going for option 2 below. With regards to dividends, the higher tax band is £46,350 so assuming you want to stay in the basic tax band this leaves you with £34,500 of dividends to take (£46,350 less £11,850) There will be some personal tax to pay on these though – the first £2,000 is tax free (dividend allowance) but after that they are charged at 7.5% tax. See below table for illustration: You can see your personal income tax on dividends would be £2,438 and your employees national insurance would be £411, resulting in net cash in pocket of £43,501. Option 2 – take a salary up to the national insurance primary threshold If you can’t claim the employment allowance or want to keep things simpler (we like simple!) 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 salary 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 18/19 is £162 per week or £8,424 for the year. Therefore we would suggest a monthly Gross Salary of £700 which stays just below this threshold and is a nice round number (as we said, we like to keep things simple!). 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 £8,400 of salary which leaves £3,450 of dividends that are in the tax free allowance, as well as the £2,000 tax free 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 tax calculation for Option 2 is : Your annual salary is £8,400 so this leaves £3,450 of dividends that can be taken tax free in the personal allowance (£11,850 less £8,400). The next £2,000 of dividends are also tax free as they are within the dividend allowance. The leaves the balance of dividends of £32,500 taxed at 7.5% = £2,438 of tax. See below for how this works out with regards to cash in pocket – it actually works out to be the same tax amount as Option 1. You will note that the net cash in pocket after income tax and employees national insurance is actually slightly higher in Option 2 than Option 1, by £411, however this doesn’t factor in the additional corporation tax you save on the higher Gross Salary in Option 1 . Comparison of optimum salary and dividends for 2018/19 See below comparison for a table which compares the two options side by side and considers the corporation tax effect as well. For limited company contractors and freelancers, Option 2 (£700 per month salary) is the recommended route – this 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 is less admin intensive as no national insurance needs paying over to HMRC. Tax planning ideas 2018/19 Here are some tax planning ideas you might want to consider to help your tax efficiency, these should be discussed with your accountant – if you’re a contractor or freelance we would advise you to speak with an accountant who specialises in providing accountancy services to the freelancer & contractor sector (like us!). Transfer a minority shareholding to your spouse so they can receive up to £2,000 of dividends 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) Finally, please bear in mind that although the tax planning strategy of paying yourself a small salary and then extracting further money from your company as dividends is currently considered relatively low risk, this does not mean that it is risk free from a HMRC challenge. We hope you have found this article about optimum salary and dividend levels for the 2018/19 tax year useful.