March 12, 2020 Optimum Director Salary and Dividends 2020/21 – Limited Company Directors When you are working through your own limited company one of the key items on your tax planning should be ensuring that you are paying yourself the optimum level of salary and dividends. The advice in this article is geared towards limited company freelancers, contractors and micro businesses with one or two directors / shareholders – at JF Financial these are the kind of clients we specialise in. First, let’s go back to basics to understand the differences between a shareholder and a director. The shareholders of a company are those who actually own the company through their holding of shares. The shareholders appoint directors to run the company on their behalf day to day. When it comes to salary and dividends, a salary may be paid to directors for performing their duties as an officer of the company, and a dividend may be paid to shareholders for their share of post-tax distributed profits. This article covers the most tax efficient structure of salary and dividends for the 2020/21 tax year (6th April 2020 to 5th April 2021) – if you would like to read our equivalent article for the 2021/22 tax year click here. As always, we would advise that you discuss your specific circumstances with a professional before taking any action. Here are some key assumptions we have made in this article: You are a UK resident tax payer with a standard personal allowance Your only source of income is your salary and dividends from your limited company There are other potential tax affecting issues that we have not covered in this article, including student loan repayments, child benefit high income tax charge and the withdrawal of the personal allowance once your income exceeds £100,000 You are not working inside of IR35 With regards to the last point about IR35 – there were some very big changes to IR35 that were due to come in from April 2020, however the government have announced that these changes have been put back one year and will now come in from April 2021 – for more info on this please read our article below: IR35 Changes 2021 How are salary and dividends taxed in 2020/21 For 2020/21 the personal allowance has remained at £12,500, which means your first £12,500 of income is tax free. For income above this the tax rates are as below (these do not apply to dividends which we discuss after this): £12,500 to £50,000 20% £50,000 to £150,000 40% £150,001 + 45% Scottish resident tax payers have slightly different tax bands for 2020/21, here: £12,500 to £14,585 19% £14,585 to £25,158 20% £25,158 to £43,430 21% £43,430 to £150,000 41% £150,000 + 46% There are further thresholds and tax issues to be aware of but we’ll keep it simple for this article. When it comes to dividend tax rates there are not separate tax rates and bands for Scottish tax payers – the dividends tax rates for 2020/21 for all UK tax payers are as follows: The dividend allowance remains at £2,000 (same as 2019/20) – this means the first £2,000 of your 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 (£12,500), that element is tax free Any dividends in the basic tax band (up to £50,000) attract a tax charge of 7.5% Dividends above the basic tax band (over £50,000) are charged at 32.5% Any dividends in the upper tax band (£150,000+) are taxed at 38.1%. As an example, if your only income was dividend income, you could receive £14,500 of tax free dividend income in 20/21. This is due to both your £12,500 personal allowance and also the £2,000 dividend allowance. Most tax efficient dividend and salary structure for 20/21 For limited company contractors, freelancers and small business owners, taking a low salary with the balance of income being extracted as dividends is a common tax planning strategy. The theory is as follows: Withdraw a low tax efficient salary, no higher than the personal allowance so that it does not attract personal tax Ensure 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 therefore corporation tax is saved at 19% (corporation tax rate for 2020/21) on the gross salary Any additional amounts you withdraw from your company would be treated as dividends which do not attract national insurance, therefore you are not paying any unnecessary national insurance Please note that dividends are not a tax allowable expense for your company (unlike a salary), so your company does not save corporation tax on the dividends Many people choose to limit their total income to the basic tax band so as not to go into the higher tax band (£50,000 for 20/21), to ensure that their income is 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. Next we discuss the optimum levels of salary and dividends for 20/21. What is the optimum level of salary and dividends for 2020/21? The introduction of the employment allowance in April 2014 enabled employers to not pay the first £2,000 of employer’s national insurance. This then increased to £3,000 in later years and has increased again from April 2020 to £4,000 for the 20/21 tax year. 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 (£12,500 for 20/21), however HMRC over the years have brought in more and more restrictions as to who is entitled to claim the employment allowance – one of which was where they said 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. Further restrictions to claiming the employment allowance have been brought in for 20/21. Unfortunately, what HMRC have left open as a slightly ‘grey’ area is the situation where, for example, 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 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) – this is clear from the fact that the government have introduced even further restrictions on being able to claim the employment allowance from April 2020. Our stand on this currently is to lean on the cautious side – in the situation of a husband and wife director payroll (for example) we would advise only claiming the employment allowance if both parties have an active role in the day to day business. For typical freelancers and contractors we would therefore advise not to claim the employment allowance and go with the simplest option – this is the option that we highlight in this article – this means you don’t need to worry about whether you are correctly claiming the employment allowance or not. 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 working inside of IR35 – as mentioned earlier, please do read our guidance about the IR35 changes from April 2021. You have a standard personal allowance Your company has sufficient post tax profits to support these dividends Optimum Directors Salary 2020/21 When it comes to tax efficient salary levels for 20/21 there are now three national insurance thresholds you need to be aware of: Lower Earnings Limit – as long as you pay a salary above this you are protecting your entitlement to future state pension and benefits, without paying any national insurance. For 20/21 this is £520 per month, £6,240 for the year Primary Threshold – if you earn above this you personally have to start paying national insurance – for 20/21 this is £792 per month, £9,500 for the year Secondary Threshold – if you earn above this your business has to start paying national insurance – for 20/21 this is £732 per month, £8,788 for the year A major change for the 20/21 tax year is that the Secondary Threshold is lower than the Primary Threshold – this means that the optimum level for the purposes of this article is to go up to the Secondary Threshold but not any higher. Therefore, we would suggest a monthly gross salary of £730 which stays just below this threshold and means no national insurance deductions and is a nice simple round amount. With regards to dividends, assuming you wish to take dividends up to the higher tax band but no further, then this would leave you with £41,240 of dividend headroom (£50,000 higher tax band – £8,760 salary). The personal tax on dividends of £41,240 would total £2,663 – this is calculated as below: £3,740 of the dividends are in the tax free personal allowance (£12,500 less £8,760 salary) £2,000 of the dividends are in the tax free dividend allowance This then leaves the balance of dividends totalling £35,500 to be taxed at 7.5% = £2,663 Below we have presented these figures in both monthly and annual columns: Please note that in order to pay this level of salary, a payroll scheme must be in place with HMRC and the salary should be reported to HMRC through the payroll system on a monthly basis (known as RTI returns) – if you have an accountant they are likely to be handling this for you, but you should check this if you are not sure. Technically, if you wish you could pay a slightly higher salary than this, up to the primary threshold, and your company would then pay the relevant employers national insurance due – you would personally not be any better off as you would end up with the same total net cash in your own pocket – but because of the corporation tax savings on the higher salary being a little higher than the employers national insurance paid, your company would be slightly better of by approx £50 for the year – but the downside of this is that you have to remember to pay the employers national insurance to HMRC on time via the PAYE system. We have decided to recommend the simpler strategy that results in the same cash in your pocket. Also, 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. Tax planning ideas 2020/21 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 freelancer 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 there are various rules to consider) Also, don’t forget about your personal tax payments on account. We hope you have found this article about optimum salary and dividend levels for the 2020/21 tax year useful.