As a small business owner one of the questions you will ask yourself is: Should I pay myself using a salary or dividends? The answer is very much dependant on circumstances and in fact many individuals choose to use a combination of the two.

With the economic situation worsening, it might well be tempting for company directors to save on employers’ and employees’ National Insurance Contributions and delay tax payments by switching from paying salaries to paying dividends on shares. If you are thinking of going down this path, do bear in mind the following:

1.  You can only pay dividends out of ‘available profits’: effectively,retained profits. If you pay more in dividends than is lawful, you can create tax problems later on and, if the company becomes insolvent, you may be liable to repay the dividends taken.

2.  Salary will count as earned income for pension contributions and dividends will not.  However if you are not going to put more than £3,600 gross into pensions per year this will not matter.

3.  If you reduce your salary too far, you may be in breach of the National Minimum Wage (NMW) Regulations. This could occur if you have a contract with the company. If you do not have a contract, as manyowners/directors do not, you will not breach these regulations.  You will normally not qualify for Working Tax Credit. If you have a contract of employment and pay yourself the NMW, you normally will.

Tax advice and tax help from an independent financial adviser is essential as there are many things to consider.

For example:

• If your income exceeds £112,950 you will reduce your annual personal tax allowance by £2 for every £1 over £100,000 which could mean you end up with an effective tax rate of up to 60% on your income between £112,950 and £150,000
• If your income exceeds £150,000 you will pay 50% income tax on your income above this level or if the income is from dividends the rate will be 42.5%
• All National Insurance rates will increase by 0.5%

This means that you may prefer to take a bonus, (taxed in a similar manner to salary) as you can decide when it is paid.

There are a few Pros and Cons when considering Salary or Dividends:

Salary Pros:

• Tax and National Insurance liabilities are easy to calculate and paid at source
• Payroll expenses are deductible from the profit chargeable to Corporation Tax
• PAYE allows you to utilise your personal allowance and starting rate of tax (10%) where applicable

Salary Cons:

• Can be used only to pay employees of the company
• Can be expensive in National Insurance for smaller companies

Dividends Pros:

• Can be paid to individuals who are not employees of the company (They must however be shareholders)
• More tax efficient in most circumstances
• No National Insurance

Dividends Cons:

• Can only be paid from the profits of the company
• Directly reduces the equity of the company

Normally unless your company is making in excess of £300,000 in profit annually, dividend payments are usually a better option than a bonus or salary increase as no NI is payable.

Most British tax payers under age 65 have a personal allowance of approximately £7,475 ( 2011-2012) which they can earn each year and not pay any tax on. In this case as a small business owner you could pay an annual salary of £7,475 using the PAYE (Salary) system and not pay any tax for this proportion of your income. You and your company will not pay National Insurance on earnings below £7,228 per annum. The remainder of your income could be made up through dividends (subject to available profits).

Dividends do not attract National Insurance and if kept within your basic rate will only attract Corporation Tax payable by the company, this is dependent on your overall company profits but for small companies should not exceed 20%. Typically this combination of Salary and Dividends will be more tax efficient than using either of the methods separately.

A financial planner can help you consider the best option to meet the individual needs of you, as a small business owner and your company. With tax help and financial planning, making the decision of whether to choose salary or dividends will be made easier.

Any questions on salaries or dividends?

Please call us on 01582 839280 or email us.