Salary versus dividends
The most efficient method for extracting profits from your company is dependent upon the prevailing rates of Income Tax, Corporation Tax, National Insurance Contributions and Capital Gains Tax. From the start of the current tax year (2011/12) Class 4 and Class 1 NICs increased by 1%, Income Tax rates remained unchanged and, on the 1 April 2011, the main rate of Corporation Tax fell by 2% and the small profits rate decreased by 1%.
so, what does mean for family companies?
The profit extraction debate centres on whether it’s more efficient to draw a salary or pay a dividend.
From the company perspective money paid by way of salary or bonus is deductible for Corporation Tax purposes. However the company, as employer, is also liable to pay employer’s NICs (13.8%). The salary/bonus is taxable in the hands of the recipient and primary Class 1 NICs are also payable.
Dividends are paid out of retained profits and, as such, are not deductible for Corporation Tax purposes, however, no NICs are payable on dividends and there is no additional tax to pay provided the recipient is a basic rate tax payer. Those within the higher and additional bands are, effectively, currently taxed at the 32.5% and 42.5% rates respectively (additional tax of 25% and 36.11% of the net dividend).
When paying dividends it is important that the company has sufficient distributable profits to cover and that the dividends are properly declared in accordance with company law. They must also be paid to each shareholder in proportion to their shareholding, unless there is either a waiver or different classes of share in existence. Bonuses can be allocated as the directors wish.
To maintain benefit of State Pension entitlement it may also be advisable to pay a small salary that falls between the lower earnings limit and the secondary threshold for NIC purposes (equivalent to between £102 and £136 per week in the current tax year).
Falling Corporation Tax rates (main rate 26% and small profits rate £20% from April 2011) and rising NI rates will tend to tip the balance in favour of dividends in many cases. From April 2011 the combined employer and main rate employee NICs (13.8% + 12%) is higher than the small profits rate of Corporation Tax (20%), with the result that the NIC saving associated with a dividend outweighs the loss of Corporation Tax relief.
A word of caution, however. Here we can only provide you with a general outline of the rules as they currently stand, at the time of writing. Before making your decision please contact us so that we can carry out a thorough assessment reflecting your specific circumstances.
A final thought on capital versus income. Although options for extracting profits in the form of capital may be limited, with Capital Gains Tax rate currently at lower levels than those of Income Tax, when combined with the availability of the CGT Annual Exemption – where the opportunity to withdraw capital is available – this could be an attractive option for some. Again, please talk to us so that we can provide you with specific advice.
