Benefiting the owner-manager: The best remuneration strategies Part 2

In part one of this series, we looked at tax efficient or exempt benefits as a way to save tax whilst benefitting the owner-manager. This time, we’re going to look at the more basic (and arguably more important) question of how to extract cash to support the owner’s lifestyle.

What we used to do

In the past it was normal to take a small salary so that neither the company or director suffered national insurance (but they counted as having made contributions for contributory benefits including the state pension), and take any further profits as dividends - avoiding the payment of employers’ and employees’ national insurance contributions.

What has changed?

The benefit of this low salary/high dividend strategy has gradually reduced as the regime for dividend taxation changed to remove the tax credit, and then the dividend allowance which followed has come down from £5,000 to £500.

As most of you will be aware, the corporation tax rate has also increased to 25% at the main rate. The threshold for marginal relief is relatively small, and whilst companies with profits under £50,000 may pay tax at 19%, employees’ national insurance (Class 1) has reduced by 4% compared to previous years. The effect of these changes means that the dividing line between salary and dividends is smaller than ever, but there can still be advantages to picking the right one!

Non-tax factors

Tax does not operate in a vacuum and I won’t make any jokes about wagging tails, but there are real implications for taking dividends over salary. Firstly, many lenders prefer salary over dividends, so an owner-manager looking to buy a new property might want to consider salary as being beneficial. It may also be relevant if redundancy ever becomes an issue, or as we saw in the Covid-19 pandemic and the operation of the government support schemes.

Further, payment of dividends requires a more complex process to formalise declaration and it is possible in some instances for HMRC to deny a dividend was made where that process wasn’t correctly followed. This can also happen in an insolvency event. It isn’t straightforward, but in some instances an insolvency practitioner could seek recovery of dividends paid to an owner-manager after an insolvency event. This is usually much harder to do with payments of salary.

If an individual is keen to make significant personal pension contributions, dividends may not provide sufficient relevant earnings to allow them to do this - although in many cases it will be more beneficial to make the contributions from their company.

Tax Factors

We will look at the inter-play between corporation tax, income tax, and national insurance in just a moment, but before we do that I want to mention one potentially relevant tax-factor: R&D claims. If a company is making R&D claims and the owner-manager is involved in the R&D process, then the value of the R&D claim should be considered in weighing up the right remuneration mix to maximise value across the business. For those not involved in R&D, it can provide a significant up-lift in the R&D related costs for which tax relief is provided, either by a reduction in corporation tax payable, or receipt of a payable tax credit from HMRC. It is only possible to get this for certain qualifying costs, which includes ‘staff costs’, i.e, salaries but not dividends.

We will now look at some worked examples of salary vs dividend in different scenarios that reflect regularly encountered real world situations.

Small Company with a single director shareholder

James operates as a consultant and his company generates pre-tax trading profits of £100,000. He takes £1,047.50 per month as a salary which uses up the entirety of his £12,570 personal allowance. In this scenario, assume there is no other income or benefits which James receives. Of course, if he does, that may impact these calculations!

James wishes to extract £50,000 of further profits and wants to know whether to extract that as a bonus or a dividend.

This is pretty clear: The dividend leaves James with over £3,000 more in his pocket. Most of this saving is made up by virtue of the basic rate dividends being charged to income tax at 8.75%, whereas salary at the basic rate is taxed at 20%.

Other considerations

The other thing we haven’t yet discussed is the timing of tax payments. If we assume that James is prudent and leaves the corporation tax in the company and therefore can take the full £36,750 of dividend declared, the tax on that dividend will be paid via his self-assessment. Clever use of loans from the company and timing a dividend to clear that loan so that no section 455 becomes due can buy James a lot of time before the tax must be paid. Contrast this to salary, for which the tax and national insurance is paid at the time of making the payment.

Small owner-managed business with several directors and employees

Assume that this company has four equal 25% shareholders that are also directors. The company generates significant profits (over £250,000) and therefore they pay corporation tax at 25%.

Our director, Helen, takes a salary of £80,000 a year. She wants to extract a further £20,000 (and no more - to preserve her personal allowance). They have the choice of taking this as a dividend or bonus. Helen has no other taxable income and the company uses its employment allowance already, so there is no additional relief on employers’ national insurance.

In this scenario, despite the dividend being slightly advantageous, in most instance the bonus will be more straightforward because of the other shareholders. If they are not also taking the same level of dividend, it might be necessary to consider dividend waivers (and the potential tax issues that come with those), or paying dividends on alphabet shares. Paying the bonus avoids these issues, and also is generally better from a non-tax point, as discussed above.

A successful business owned by a husband and wife

This time, our hypothetical company makes profits of £2m a year. The husband and wife director shareholders each take a salary of £150,000 and therefore get no personal allowance and they pay income tax at the additional rate. They have agreed to extract £100,000 each.

This makes it clear that salary is now better than bonuses at higher rates of tax in terms of the absolute take home. However, one must still weigh up the timing of tax paid and the reason why funds are needed. It may be that the owner-manager would rather defer the tax.

Our owner-mangers may also get a benefit if they were to take £100,000 salary each in one year, and then £200,000 in the next and repeat this alternating strategy. By doing this, every other year they’d get access to their personal allowances and save around £5,000 in tax every two years, but average the same income over that time. Again, other factors may be relevant (such as can they sustain their lifestyle - which might necessitate loans from the company).

A business with accumulated profits to be extracted

In this final example, our director shareholder has been accumulating funds in the company for a number of years, but now wants to take a large bonus. He has £400,000 in funds to extract. The company will pay corporation tax at the main rate despite this bonus.

As you can see, the larger the amounts extracted, the bigger the benefit of taking a bonus instead of a dividend. However, the difference, even at a £400,000 is only £4,000 in tax and so it really highlights how close dividend and bonus remain.

Alternative options for large extractions

There are, of course, some other things that can be done to minimise tax. In our final scenario, depending on the owner’s lifestyle and desire to save tax, they could consider moving to a low tax jurisdiction and ceasing to be UK resident. They might be able to then extract funds either by way of dividend or salary and pay significantly lower tax. There are some foreign countries which offer attractive tax regimes for digital nomads (I’m especially thinking of Malta here, although there are others). Of course - this can create additional tax issues, not least corporate residence problems. But structured right, it could potentially save around £160,000 in our £400k bonus example above. Some might consider a year in a sunny climate a small price to pay for such a boon.

For those not keen on such drastic options, something else that can commonly help high earning owner managers is to alternate the level of salary year-to-year to access the personal allowance. The benefit to doing this can mean that rather than the high-earning owner-manager losing their personal allowance every year, they can get it one year then not the next (if their income goes over £125,140).

Next time, paying subscribers can see how this all comes together in real-life examples of building the perfect remuneration strategy for different types of clients.

Remember - if you are a paying member of Taxing Thoughts you can request analysis by emailing requests@taxingthoughts.co.uk