Dividends vs Salary – which is the most tax-efficient way to take profits from my business?
How you are paid can have a significant impact on the amount of tax that you owe. That is why most business owners are paid via a regular salary, as well as dividends – an amount paid out from a company’s profits to shareholders.
Getting this balance right can sometimes be the difference between paying tax at the basic, higher and additional rate, as well as affecting other personal tax reliefs and National Insurance contributions.
How are dividends taxed?
By balancing your salary and the dividends you receive you can mitigate the amount of tax you pay.
Every taxpayer has a tax-free dividend allowance of £2,000. Any dividend income over this amount will be taxed at your marginal rate as follows:
- Basic rate – pay 8.75%
- Higher rate – 33.75%
- Additional rate – 39.35%
These rates increased by 1.25 percentage points from April 2022 as part of the Health and Social Care Levy.
How much salary should I pay myself?
Finding the right combination of salary vs dividends often relies on several factors, such as:
- Company profitability
- Personal tax liabilities
- A company’s tax arrangements
- Desire to retain state benefits.
To accumulate qualifying years for the state pension your salary must be at or above the NIC Lower Earnings Limit (currently £6,396).
If you earn more than the NIC Primary Threshold (currently £9,880 rising to £12,570 from July 2022) you will have to pay NICs from your salary.
You will start to pay income tax on your salaried earnings above the personal allowance (currently £12,570).
Are there any benefits to paying myself a salary?
Given the potential tax savings on offer, you might wonder why you should get paid a salary at all. However, here are some benefits to consider:
- Accumulation of qualifying years towards your state pension
- Retaining maternity and paternity benefits
- Easier to apply for mortgages and insurance policies
- Salaries are allowable business expenses for Corporation Tax purposes
- Salaries are paid even if your business makes no profit.
Be aware, however, that drawing a salary requires both you and the company to pay NICs.
Should the company pay for my car?
A company car can be one way of reducing your annual tax bill but they are still taxed through Benefit-In-Kind (BIK).
This classes a company vehicle as an extra taxable benefit that falls outside of your regular salary.
The latest BIK rates follow the stricter European World Harmonised Light Vehicle Test Procedure (WLTP) emission and economy tests, which means that some cars on paper will have higher CO2 (carbon dioxide) emissions, resulting in a higher rate of tax.
Companies should use the latest car tax rates to reduce their BIK liabilities by selecting lower-emitting vehicles.
Is it more tax-efficient to have an electric company car?
The Government has set up numerous tax incentives for company car users who use electric vehicles (EVs).
It is not surprising then that more businesses have either already made the switch to EVs or are giving serious consideration to doing so. Some of these incentives include the following:
- Benefits in Kind – EVs attracted a 1% tax rate on Benefit in Kind (BIK) in 2021/22. This also applies to hybrid vehicles with emissions from 1 – 50g/km and a pure electric range of over 130 miles. This rate has increased to 2% in 2022/23, but it still makes electric and low emission cars very affordable in comparison to higher emission vehicles.
- Capital allowance – Cars with CO2 emissions of less than 50g/km are eligible for 100% first-year capital allowances. This means that electric cars can deduct the full cost from your pre-tax profits. There may be Corporation Tax to pay when the car is later sold, so this needs to be considered.
- Congestion charge exemptions – EVs are exempt from congestion charging and clean air zone (CAZ) charges. As well as London, five cities have been required by the Government to introduce a Clean Air Zone, including, Leeds, Birmingham, Nottingham, Derby and Southampton. If your company vehicle regularly travels into areas where clean air zones exist, there will be significant cost savings from switching.
- Electric charge points – Any business that installs charging points for electric vehicles between now and 31 March 2023, can claim a 100% first-year allowance for these costs through the Workplace Charging Scheme worth up to £350 per charging point.
- Electric vans – The taxable benefit for having the private use of a zero-emission van were reduced to nil from April 2021. The previous year, electric vans were taxed at 80% of the benefit for a normal van.
- Government grants – The Government’s plug-in car grant provides 35% of the purchase price up to £1,500 towards the cost of an eligible plug-in vehicle costing less than £32,000. This plug-in car grant applies at the time of purchase and is typically given as a discount on the purchase price of a vehicle.
- Leasing – Leasing a vehicle through a VAT registered company allows you to claim back 50% of the VAT on monthly payments and up to 100% of the VAT on the maintenance agreement, which you are not allowed to do when buying a vehicle outright. But be aware that a leased EV will not qualify for the Capital Allowances mentioned above.
- Salary sacrifice – Where an electric car is provided under salary sacrifice, the optional remuneration rules do not apply.
- Tax bands for low emission vehicles – 11 new tax bands for vehicles with emissions of 75g/km and below have been introduced. The Government has also announced the tax rate for the next three years, helping businesses to plan. Electric and hybrid vehicles pay no or very little vehicle excise duty.
What is a director’s loan account?
A director’s loan account is a method for keeping track of the transactions between you and your company.
This acts as a record of money taken out of a limited company, which isn’t:
- Dividend; or
- Business expense repayment.
It also accounts for any money lent to the company by you or another shareholder, which could cover the purchase of new equipment, a cash flow injection or other investments.
How do you prepare a director’s loan account?
HM Revenue and Customs (HMRC) must be provided with a director’s loan accounts through annual company returns.
In your director’s loan account, you should record:
- Cash withdrawals and repayments you make as a director
- Personal expenses paid with company money or a company credit card
- Interest charged on any loans.
What does an overdrawn directors’ loan account mean?
If you take more money out of the company than you put back in, the loan account can become overdrawn.
Any overdrawn amounts are considered to be assets of the company on your balance sheet until they are repaid.
If you’re a shareholder and director and you haven’t been charged interest on money you owe to your company of more than £10,000 your company must:
- Treat the loan as a ‘benefit in kind’
- Deduct Class 1 National Insurance
This must also be recorded on your tax return and may result in tax on the loan at the official rate of interest.
Therefore, money should be paid back within nine months of the end of the accounting period to prevent a significant tax bill from arising.
There are other Corporation Tax implications of an outstanding overdrawn loan account 9 months after the balance sheet date.
What is a balance sheet?
A balance sheet provides a statement outlining the assets of the company owners, its liabilities, such as debts, and the value of its owner’s investment referred to as shareholders’ equity.
The first section of a balance sheet records a business’s fixed assets, such as buildings, land, machinery and equipment, and current assets, which includes cash, stock and accounts receivable that have a ‘lifespan’ of one year or less.
The next section records liabilities, including long-term liabilities like money owed by the company that aren’t due to be repaid within the year, current liabilities that must be paid sooner, such as money owed to HMRC that is paid with 12 months, and accounts payable, which includes salaries and interest on loans.
The final part of the balance sheet is the shareholder equity, which will typically include:
- Share capital – The funds given in exchange for shares.
- Retained earnings – Profits earned once dividends or other distributions are paid out.
For a balance sheet to balance, total assets have to equal total liabilities plus shareholders’ equity. When combined with cash flow records and an income statement the balance sheet should form part of a business’s financial statement.
How do I understand my Balance Sheet?
A balance sheet can give you a great deal of insight into your business and its financial health, helping you improve cash flow, manage debts or seek finance and investment.
To better understand your balance sheet there are two key ratios to consider:
- Current ratio – Current assets divided by current liabilities – This gives you a picture of how much cash you have to run operations.
- Debt-to-equity ratio – Total liabilities divided by shareholder equity – This shows you how much money the business owner needs to cover debt obligations.
How can I improve my balance sheet?
There are many different approaches to improve your balance sheet and boost cash flow. Here are four common steps that all businesses should consider:
- Improving debt-to-equity ratio – Reducing your debts and increasing the cash coming into your business can only strengthen your operations. You need to increase your income and use this to pay down debts. If you can’t increase income, you may need to use assets to reduce debts.
- Create a cash reserve – Monitor the amount of cash held and try to build a reserve for investment or emergencies. This can be achieved by disposing of assets, increasing turnover or reducing liabilities.
- Reduce cash leaving the business – Cash flow is the lifeblood of your business. If your liabilities exceed the cash being received you cannot operate and you should find a way to manage liabilities.
- Strengthen credit control – Many businesses struggle with debts and late payments. These can create a lot of issues with cash flow and balance sheets. Appoint a professional to manage credit control or invest in software that can help do it for you.
What is depreciation?
Depreciation refers not only to the decrease in the value of a tangible asset but also the process of writing down the cost of the asset during its useful lifespan.
It can be useful to depreciate the value of long-term assets on a balance sheet as this can affect net income, which may have accounting and tax benefits
The method for calculating depreciation can sometimes vary between asset types, which can affect how assets are accounted for and taxed.
What methods of depreciation are used in the UK?
There are two main methods used to calculate depreciation:
- Straight-line method – This is calculated by dividing the difference between an asset’s cost and its expected salvage value by its useful lifespan. This method is easy to calculate and understand but has some drawbacks.
- Reducing balance method – This is calculated by applying a fixed percentage on the ‘book value’ of the asset each year so that the amount of depreciation each year is less than the amount provided for in the previous year. As the ‘book value’ of the asset is continually reduced from year to year it is possible to figure out the depreciation expense.
What is amortisation?
Amortisation is a method used to lower the value of a loan or an intangible asset, such as a patent, over a period of time.
Amortisation is used by lenders to calculate a loan repayment schedule based on a specific maturity date.
Meanwhile, for intangible assets, amortisation helps tie the cost of the asset to the revenues generated by the asset following the matching principle of generally accepted accounting principles.
What is an Asset Register?
An asset register is used to list a business’s physical resources, including the date assets were purchased, calculations of their value and identify their current location within an organisation.
Asset registers allow owners and their accounts to compare the value of the assets against their ledgers or balance sheets and calculate depreciation.
Businesses may operate more than one type of register to account for fixed tangible assets, intangible assets or even specific registers for different departments, such as an IT asset register.
Fixed assets registers can be maintained within the business’s accounting software.
What does EBITDA mean?
EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortisation and is a method used to evaluate a company’s financial health and performance.
This method shows a business’s profitability from its operations before the effect of capital structure, leverage and non-cash items, such as depreciation, are accounted for.
Should I operate as a sole trader, a partnership or a Limited Company?
The structure of your business can have a big impact on how you and your new enterprise are taxed and the obligations that you face.
Sole traders – From a legal and tax perspective you and your business are considered a single entity.
As such, you are held personally responsible for the business and its debts.
Your profits are declared via a self-assessment tax return and classed as your annual income for that year, regardless of whether you receive this as a salary or it is held in your business’s bank account.
As a sole trader, you do not have to submit information to Companies House each year, it may be easier to take money out of the business and it can be easier to set up and close your business but remember you are personally liable for the debts of your business.
Partnership – Partnership are similar to sole traders but differ in that they have more than one owner.
Under a partnership arrangement, each partner owns a specified percentage of the profits but is also liable for these profits and must pay tax on them as they are treated as income.
Each partner must complete a self-assessment tax return to record and report their income to HM Revenue & Customs.
Depending on the type of partnership formed, partners may be held personally liable for debts and other obligations.
Limited liability partnerships share many of the same characteristics of a conventional partnership, such as the internal management, tax liability and the distribution of profits, but also provide the limited liability of an incorporated company, without the same obligations.
Limited Company – Incorporating a business is a popular choice for many business owners, as the business becomes a separate legal entity entirely.
The company will be owned and controlled by those who own its shares. These shares can be owned by a single person or multiple people and can be sold to raise money for the company.
Limited companies must be registered at Companies House and have to submit annual accounts and statements under Companies House rules. They will also have certain standard legal documents that govern what they can and can’t do.
Instead of partners or owners paying tax via their tax return, Limited Companies are subject to Corporation Tax and must submit an annual Corporation Tax return which records your company’s:
- Income and expenditure
- Details of any stock on hand at the end of your financial year.
Choosing to operate as a limited company comes with significant benefits for owners and shareholders, including improved tax efficiency and reduced risk from liabilities.
It is important to carefully consider which structure suits your business and how it may affect the tax that you owe and your legal obligations.
It is possible to change your business’s structure later in its life.
Operating as a company may also add a level of credibility that you may not associate with as a sole trader.
What is IR35?
It was previously a contractor’s responsibility to determine their IR35 status while working in the private sector, regardless of whether they were operating as a limited company or through an agency.
However, since April 2021, the duty to make this determination has shifted from the contractor operating via a personal service company (PSC) to the end client, which will typically be the engager of a contractor’s services or the recruitment agency through which they are contracted.
How does IR35 affect my business?
All medium and large businesses are now accountable for determining the IR35 status of contractors and paying the appropriate taxes and National Insurance contributions via PAYE.
Most importantly they, and not the contractor, are held liable if HM Revenue & Customs determines a contractor’s IR35 status has been incorrectly assessed.
The change does not apply if the end client is classed as a small business or the contractor is engaged through an umbrella company and is already being taxed through PAYE.
Small companies must meet two out of the three conditions below to be exempt:
- an annual turnover of less than £10.2 million
- a balance sheet total of less than £5.1 million
- fewer than 50 employees
How do I determine IR35 status?
There are three key questions for determining IR35 status:
- Are contractors directly under your control and direction or do they have autonomy?
- Do they have the right to provide a substitute in a contractual agreement?
- Is there a mutuality of obligation where you expect a worker to undertake work when asked to do so, and the worker expects to be given work constantly?
The answers to these three questions will help you establish your relationship with contractors and whether they should be deemed inside or outside of IR35.
To help employers HMRC has created the Check Employment Status for Tax (CEST), which can be found here.
What is Making Tax Digital?
Making Tax Digital (MTD) is the first stage in HM Revenues & Customs (HMRC) strategy to digitise the UK tax system.
This new tax system will require businesses to use HMRC-compliant software to submit information digitally quarterly under a phased plan, which is already underway.
HMRC believes that this new approach will help taxpayers by ensuring the information they hold is accurate and up to date.
Under this system, businesses and taxpayers will have to make additional submissions each year, as well as completing an annual final tax return as they already do.
At present, MTD has only been integrated into the VAT system, but it will eventually be phased in for all forms of taxation.
How does Making Tax Digital affect my business?
MTD will be introduced in several different phases, as follows:
Making Tax Digital for VAT
If your business is VAT registered you will need to comply with Making Tax Digital (MTD) for VAT.
Under this system you must use HMRC approved software to keep your records digitally and submit VAT returns each quarter.
An initial soft-landing period for MTD for VAT has ended, which means that businesses face potential penalties if they do not use HMRC-compliant software or process to report their VAT affairs.
Making Tax Digital for Income Tax
MTD for Income Tax Self-Assessment will require the self-employed and landlords with annual gross business or property income above £10,000 to comply with MTD from April 2024 by recording and reporting their income using HMRC compliant software every quarter. General partnerships will also have to abide by these rules from April 2025.
If this change affects you, you will need to complete four annual submissions, plus an annual return digitally.
The Government has announced a more favourable point’s system of penalties for the late filing and late payment of tax for MTD for Income Tax Self-Assessment.
This will come into force in the tax year beginning April 2024 for the self-employed and landlords, and April 2025 for all other ITSA taxpayers, such as general partnerships.
Making Tax Digital for Corporation Tax
HMRC intends to introduce its MTD initiative into the Corporation Tax regime once it has finished rolling out the system for Income Tax but it is yet to set a firm date for its implementation.
At the moment, not much has been confirmed about this phase of MTD, as the Government is still consulting with businesses and their agents to help design an effective MTD for Corporation Tax system.
The Government will also provide businesses with an opportunity to take part in a pilot for MTD for Corporation Tax before it becomes mandatory in the years ahead.
What software can I use to comply with Making Tax Digital?
You must use HMRC approved cloud accounting software or a set of compatible software programs that can connect to HMRC systems via its Application Programming Interface (API). The software must be able to:
- Keep records in a digital form
- Preserve digital records in a digital form
- Create a VAT or tax return from the digital records held in functional compatible software and provide HMRC with this information digitally
- Provide HMRC with VAT and tax data voluntarily
- Receive information from HMRC via the API platform that the business has complied.
We can help you find online cloud accounting software that is suited to you and your business’s needs.