For limited company contractors, working out the most tax efficient way to draw down income from your company should be a priority. In this article, we look at the factors you should consider when setting your annual salary level this tax year, and what dividends are, and how they are taxed.
Umbrella company contractors
If you are a PAYE umbrella company employee, your income will be subject to standard PAYE (Pay-As-You-Earn) income tax deductions and National Insurance Contributions. Although there may be differences in service charges, and the value of ‘perks’ offered by different umbrella scheme operators, you should be subject to exactly the same levels of taxation. It is unethical for umbrella firms to claim otherwise.
Limited company contractors
If you are a limited company contractor, you will have a lot more flexibility over how and when you pay yourself.
Assuming your contract work is not caught by IR35, most limited company contractors extract income in the form of dividends, and a small salary. The main tax benefit of incorporating is that dividends are not subject to National Insurance Contributions (NICs), whereas salaried income is. As a result, an average limited company contractor on around £300 per day, taking six weeks off per year, might save around £8,000 compared to an umbrella employee.
What salary should I pay myself?
It is worthwhile drawing a salary from your company, as this cost is deductible against the company’s Corporation Tax bill.
However, the tax benefits of drawing a salary diminish as you pass through the prevailing income tax and NIC thresholds.
a) £8,060 salary
Here are some of general factors to consider when setting your salary level (and that of your spouse, if applicable):
- If you are entitled to the full personal allowance, you will not pay any income tax at all if your salary level doesn’t cross this threshold. For 2016/17, the personal allowance is £11,000 (in 2015/16 it was £10,600).
- For the 2016/17 tax year, you only start paying Employees’ National Insurance Contributions when your annual salary reaches £8,060 (unchanged from previous year).
- For the 2016/17 tax year, your company only starts paying Employers’ National Insurance Contributions when your annual salary reaches £8,112 (unchanged).
- As a result, if your company is not claiming the Employment Allowance (see below), £8,060 remains a tax efficient salary to draw this year.
- Make sure you take into account any other income you have already received in the current tax year (for example, if you received a salary from a previous job or have rental income).
- There is no legal requirement to pay yourself the National Minimum Wage, unless you have a contract of employment with your own company which states otherwise (this is very unusual).
b) £11,000 salary (claiming the Employment Allowance)
If you are not caught by IR35, and you are not the sole director of your company without any other employees, you may benefit from paying yourself a higher salary than £8,060, and claiming the Employment Allowance (EA) as follows:
- The EA, which was first introduced in April 2014, will refund any Employers’ NICs your company pays, up to a maximum of £3,000.
- You will still have to pay Employees’ NICs on any salary over £8,060.
- So, if you pay yourself £11,000 during the current tax year, you will pay no income tax at all, the salary is deductible against your company’s Corporation Tax bill, and you’ll pay £352.80 in Employees’ NICs. The £398.54 Employers’ NICs will be refunded via the Employment Allowance (EA) scheme. However, you cannot claim the EA if you are the sole director of your company, and have no other employees.
- Your company will also save £588 in Corporation Tax if you decide to take a £11,000 salary instead of £8,060.
- So, overall, you are better off paying yourself a £11,000 salary during 2016/17, if you are eligible to claim the EA.
- You can find out more about the EA, and see a calculation here.
How do dividends work?
- Your company is entitled to distribute dividends from its retained profits, i.e. the profits in the company after all expenses and tax obligations have been met.
- There are no rules which dictate how often you declare dividends; the key thing is that the company must have sufficient profits to do so at any given time.
- Dividends must be paid to shareholders in amounts matching the percentage shareholdings owned.
- To make a legitimate dividend declaration, the company must record the decision via board meeting minutes, and must provide each shareholder with a dividend voucher (paper, or electronic). You can download templates here.
- You should keep your dividend vouchers safe, as you will need to use the information when filling in your annual self assessment return.
- You may decide to split ownership of your company with your spouse (if applicable). This will enable you, as a couple, to benefit from your joint tax-free allowances, especially if the spouse has no other forms of income.
- As a company director, you have the power to decide when to declare dividends. You may decide to postpone making a declaration until the following tax year, to minimise your higher rate tax liability, for example.
- As a company director, you settle your outstanding tax liabilities via the annual self assessment process.
How are dividends taxed?
On 6th April 2016, the way dividends are taxed changed significantly. Instead of a system of tax credits, there are now just fixed dividend tax rates, as follows:
- 7.5% (basic rate)
- 32.5% (higher rate)
- 38.1% (additional rate)
Dividends are taxed as the ‘top slice’ of income, so after you have taken into account your salary, and any other earnings.
There is also a £5,000 ‘dividend allowance’, however this sits within your existing tax bands.
Find out more in our popular guide: how much will the April 2016 dividend tax changes cost you?
You can find out more about what dividends are, and how to account for them in our detailed guide to limited company dividends.
If you are starting out as a contractor and need to find an accountancy provider, try our growing directory of accountants for some initial suggestions.
Although the information contained on our site is verified by our own accountant, this article should be used as a guide only. Please contact your own accountant if you have any questions.