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Limited company contractors - salary vs. dividends

Published on Apr 1, 2009 |

Planning the salary as a limited company director is an essential way for contractors to save tax.

By choosing an effective combination of salary and dividend you can maximise your tax savings.

A salary is an annual payment made by the company to the Director usually payable at monthly intervals.

The gross annual salary is subject to employees and employers' NICs (national insurance contributions) and personal tax on the director.

There is no actual requirement for the director to pay any salary at all, but it would be normal for the director to do so.

The gross salary and employers NICs are a deductible expense against the profits made by the limited company and so reduce corporation tax payable by the company.

Setting the level of salary is dependent on various factors:

National Minimum Wage Legislation
Working Tax Credits, Job Seekers Allowance and Other State Benefits
Earnings from a previous job in the same tax year
State Pension Entitlement
Personal or Company Pension Contributions
Personal Tax Allowance
National Insurance Contributions

National Minimum Wage Legislation

If the company is trading and the director is employed by the company on a contract of employment then the company has to pay the director a salary, even if it is only payable at the national minimum wage (£5.73 per hour aged 22 and over (01/10/08).

If the Director is not employed on a contract of employment then National Minimum Wage legislation does not apply and the salary is a taxable payment for the official role as a director of the company, and the fee earner.

Working Tax Credit, Job Seekers Allowance and other State Benefits

You may need to ensure that you have a contract of employment from your limited company if you are claiming Working Tax Credit, think you may need to use Job Seekers Allowance or have any other state benefits. The number of hours and the hourly rate may affect any or all of these benefits and you should take advice on this.

If you have a contract of employment with your company then National Minimum Wage Legislation applies.

Earnings from a previous job in the same tax year

If your first year's trading is in the 2009-10 tax year and the director has earned income in another employment then this employment income can be taken into consideration when deciding the salary of the director.

For instance, the director may have already earned enough income in a tax year to cover the minimum National Insurance Contributions for State Pension Entitlement, Company Pension Contributions, and use of the Personal Tax Free Allowance.

State Pension Entitlement

The State Pension Entitlement is based on the person paying a minimum number of years' National Insurance and so your entitlement to this can be affected by the level of National Insurance Contributions.

You may need to check your personal forecast for State Pension before making a decision and you can obtain that from The Pension Service but as a general rule of thumb if you have worked the required number of years a minimum salary of £5,720 is required in the 2009-10 Tax Year.

Personal and Company Pension Contributions

If either you or your company is making Pension Contributions you may need to take advice regarding the minimum salary your company can pay without having problems with HMRC.

As a rule of thumb guide you should not experience any problems up to 100% Pension Contribution of your salary.

Personal Tax Allowance

The tax free Personal Tax Allowance for 2009-10 is £6,475 for 2009-10 so calculating your payroll as a salary of £6,475 over 12 months of the tax year will result in a £0 PAYE tax liability and effectively uses up your Personal Tax Allowance.

If you had less of a salary than this, your Personal tax Allowance would still be used up if you also received dividends, so it is not lost.

National Insurance Contributions

Your company will start to pay employers' national insurance at 12.8% of your Gross Salary, once you as a director have earned £5,720 in the 2009-10 Tax Year.

Up to £5,720 in the 2009-10 Tax Year there is no Employers' National Insurance.

The 2009-10 Tax Year starts on 6th April 2009, so if your company starts paying you in July you have 9 months in which to earn £5,720 before your company starts to pay employers' national insurance.

As an employee a director will pay employees national insurance at 11% on all salary once you have earned £5,720 from your company in the Tax Year 2009-10.

Below £5,720 in the 2009-10 tax year there is no employees national insurance.

Once you have earned £43,888 the employees national insurance rate reduces to 1%.

The 2009-10 Tax Year starts on 6th April 2009, so if your company starts paying you in July you have 9 months in which to earn £5,720 before your company starts to pay employees national insurance.

Your Remuneration Strategy

A limited company director may choose to organise their business matters by paying a relatively modest salary in order to accumulate profits in the company that can then be paid out in the form of tax effective dividends.

The combination of this salary and dividend is your remuneration strategy and your decision is based on the factors listed above.

PAYE also provides additional benefits to the employee such as Statutory Sick Pay (SSP), Statutory Maternity Pay (SMP) and Statutory Paternity Pay (SPP) from the company.

Each director needs to look at their individual circumstances to decide, but one practical salary level for a director who does not need to have a contract of employment with his company, or maintain a certain salary for pension contributions, is £6,475 in one tax year.

At this rate, both employees and employers national insurance are paid, and the personal tax allowance is used up.

About the Author

Article kindly provided by Phil Richards from Blevins Franks Chartered Accountants. For a worked example of how this all works please visit the Blevins Franks website.

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