A popular way for directors/shareholders of small companies to take money out of their company is to pay themselves a small salary and take the rest out in dividends. So for the next tax year (2019/20) what should the salary be set at to ensure a director pays the least amount of tax?
In the absence of the employment allowance (which is not available to companies where the sole employee is also a director), the optimal salary for 2019/20 is £8,632 a year. At this level, no tax or employee’s or employer’s national insurance is due. The salary is also deductible for corporation tax purposes. Beyond this level, it is better to take dividends than pay a higher salary as the combined national insurance hit (25.8%) is higher than the corporation tax deduction for salary payments.
As well as this strategy being tax effective, taking a small salary is also advantageous in that it allows the individual to secure a qualifying year for state pension and contributory benefits purposes.
Dividends can only be paid if the company has sufficient retained profits available. Unlike salary payments, dividends are not tax deductible and are paid out of profits on which corporation tax (at 19%) has already been paid.
However, dividends benefit from their own allowance which is set at £2,000 for 2019/20 and payable to all individuals regardless of the rate at which they pay tax. Once the allowance has been used, dividends are taxed at lower rates than salary payments (7.5%, 32.5% and 38.1% rather than 20%, 40% and 45%).
Once the optimal salary has been paid, dividends should be paid to use up the dividend allowance. If further profits are to be paid out, there will be tax to pay, but the combined tax and national insurance hit for dividends is less than for salary payments, making them the preferred option.