The introduction of the Employment Allowance (“EA”) allows employers a discount of up to £2,000 off their liability to Employers’ NIC. This has added another factor into the salary vs dividend debate.
There is one other complicating factor as well. The level of other taxable, non-dividend, income enjoyed by the director/shareholder.
If there’s no other income
A salary equivalent to the director’s personal allowance is most efficient. The additional NIC paid by the director (at 12% on the excess over £8,060) is more than compensated by the additional corporation tax saving at 20%.
With no other employees, this works for companies with up to 5 directors/ shareholders.
What if the director has other income?
Many directors own the company premises, and enjoy a rent from that. Where rent (or indeed any other taxable income) is enjoyed by the director, a little more care is needed. The optimal position would be to create total taxable income (excluding dividends) of exactly £10,600 (for 2015/16). So if the director was receiving rent of £3,000 a year, the ideal salary would be £7,600.
What about pensions?
There are two aspects to this.
Contributions to a private pension scheme
Dividends do not count as pensionable income, and so tax relief on personal contributions would be limited to the amount of taxable salary. (Rent doesn’t count either).
The simplest way around this is to get the company to make an employer contribution, but you may need a different kind of pension scheme, and this may need to be negotiated/agreed with fellow directors.
I had just such a case where one of three directors wanted to top up his pension. Unfortunately, the wider savings from the low salary route meant his tax relief was limited to just £5,000, as he already had two smaller schemes running, and the company did not have sufficient profits to get full tax relief on even that small amount.
State pension entitlement
Employees are credited with a year’s worth of contributions if their weekly earnings exceed £112.00 (2015/16 rates). Therefore, the director will need a salary of at least £5,824 to add another year to their state pension accrual. In the example above, a salary of £7,000 meets the criteria, but what if the rental income was £6,000?
Voting a salary of £5,824 would take the director into income tax, as total income would exceed the personal allowance.
At 2015/16 rates, this would impose an income tax bill of £244.80 on the director, but would add a year to the pension entitlement. The cost-benefit decision is personal to each individual; is an extra year’s pension worth paying that tax?
The factors to consider are:
- how many years before you can take your pension,
- how long you think you’ll be around to enjoy it, and
- how much more could you generate in income by saving that tax over the years before you retire/
Creating alternative income
If the circumstances allow, it may be more efficient to draw one’s income as rent or interest from your own company, rather than by way of salary.
Any rent charged must be at a market rate. We would suggest that a written agreement is drawn up, making it clear who is responsible for repairs etc., as well as covering the amount of the rent.
A director can only charge interest to his company if he has a loan account in credit, and there is an obligation on the company to pay interest. Any “interest” paid on a loan which was intended to be interest-free could be challenged and treated as remuneration. In order to avoid any uncertainty, we would suggest a written agreement, which makes clear the terms of the loan. The agreement does not need to be onerous, but a clear statement can help to avoid later disputes.
The start of a new tax year is a good time to review your financial positon, as many rates and allowances change. Thankfully, for directors’ salaries, the annual earnings period means you haven’t lost out if your review has not yet been completed.
Contact your advisor, or drop us a line if you’d like a review done of your personal situation.