Salary or Dividends? – How do I draw earnings from my company?

Should you take your income as salary or dividends? The question of how to draw earnings from your business when you are an owner director is a perennial one, but in recent years, successive changes in government policy have made the answer slightly more nuanced. There is no ‘one size fits all’ response and there are multiple factors to consider before one can give a concrete answer. However, here are the key criteria we would be looking at when helping a client make that decision.

Who pays the tax?

You’re probably not surprised to learn that the fundamental difference between drawing income through dividends or salary comes down to a question of tax. If you take a basic salary and supplement it with dividends, subject to the performance of the business, the business bears the brunt of the tax liability. This is because the amount of overhead cost (salary) is nominal, leaving more profit in the business. Corporation tax is calculated on profits before dividends and so the more profit you retain in the business, the more corporation tax there is to pay. Personally, you pay a small amount of tax/NI on the salary and then pay tax on the dividends – declared via your personal tax return.

If the majority of your income is paid through a PAYE salary, then this increases the cost to the business, therefore reducing the profits and in turn the corporation tax liability. But your personal tax liability increases and you pay income tax and NI through the normal PAYE route.

Dividend Allowance

Whilst various governments tweaked the corporation tax rate, impacting the amount of tax liability on the business, a salary/dividends hybrid was always the most tax efficient means of drawing income. That was until a dividend allowance was introduced. For the first time this capped the amount of tax free dividends that could be drawn from a UK company. Initially set at £5k and subsequently reduced to £2k, the allowance moved a proportion of the tax liability back to the individual. Whilst dividends beyond the threshold are taxed at a lower rate, the allowance was introduced in a bid to level the playing field for owner/directors and employees.

At £2k allowance there is a point whereby the benefit of drawing income via salary/dividends, from a personal tax perspective, is nullified. Of course, tax is not the only driver for drawing a basic salary and dividends and there are other significant matters that should be considered. For instance, it also allows business owners with more seasonal income trends to take an income that reflects the profit and cashflow.

Personal Tax Planning

As noted, the question of who pays the tax is normally the fundamental starting point for deciding which route to follow, but when the tax is paid also makes a difference. With a pure salary route, the tax is declared and paid as part of the payroll process and you may prefer this – after all it’s one less thing to remember.

For a salary/dividends hybrid, the point at which the tax is paid by both the company and individual is delayed. For the company, they will declare their profits as part of their annual accounts, with corporation tax payable 9 months and 1 day after the end of the financial year. Your tax liability will be calculated as part of your personal tax return/self-assessment. The deadlines for this remain the same, being submission and payment by 31st January following the end of the tax year. For some, this delay in paying the personal tax is welcomed, but for others it merely delays the inevitable and creates one larger tax bill as opposed to multiple smaller tax payments. This becomes a matter of personal preference and regardless of tax, cashflow and profits, personal preference remains one of the biggest factors when making the call between salary or dividends.

Based on search data to our website, this series of blog posts is designed to answer some of the most common ‘how to’ queries around setting up, running a company and managing your personal and commercial tax affairs. If there is a particular question you would like us to answer, please contact us today. Click here to view all the articles in this series.

This entry was posted on Monday, 19th July 2021 at 9:36 am and is filed under Business Advice, Personal Tax, SME Questions.

Tags: dividends, drawings, owner, questions, salary, SME