Wondering whether to use dividends or a salary? Read this blog to find out why dividends are more cost-effective.

Director’s salary or bonus?

Given current tax rates, paying a dividend rather than a salary will often be a more cost-effective way of withdrawing profits from a company.

Tax is currently payable on any dividend income received over the £2,000 annual dividend allowance at the following rates:

  • 7.5% on dividend income within the basic rate band (up to £37,500 in 2019-20)
  • 32.5% on dividend income within the higher rate band (£37,501 to £150,000 in 2019-20)
  • 38.1% on dividend income within the additional rate band (over £150,000 in 2019-20)

However, if the company is loss-making and has no retained profits, it will not be possible to declare a dividend, and an alternative will need to be considered. This often involves an increased salary or a one-off bonus payment.  

From a tax perspective, the position will be the same whether a salary or bonus is paid. Both types of payment attract income tax at the recipient’s relevant rate of tax (20%, 40% or 45% as appropriate).

However, from a National Insurance Contributions (NICs) perspective, the position, and any potential cost savings, will depend on whether or not the payment is made to a director.

Directors have an annual earnings period for NIC purposes. Broadly, this means that NICs payable will be the same regardless of whether the payment is made in regular instalments or as a single lump sum bonus.  In addition, since there is no upper limit of employer (secondary) NICs, the company’s position will be the same regardless of whether the payment is made by way of a salary or a bonus.

Where a bonus or salary payment is to be made to another family member who is not a director, the earnings period rules mean that it may be possible to save employees’ NICs by paying a one-off bonus rather than a regular salary.

Example

Henry is the sole director of a company and an equal 50% shareholder with his wife Susan. In 2019/20 they each receive a salary of £720 per month.

In the year ended 31 March 2020, the company makes profits of £24,000 (after paying the salaries). The profits are to be shared equally between Henry and Susan. They want to know whether it will be more cost effective to extract the profits as an additional salary – each receiving an additional £1,000 per month for the next twelve months – or as a one-off bonus payment with each receiving £12,000.

The income tax position will be the same regardless of which method is used.

As Henry is a director, his NIC position will be the same regardless of which route is taken as he has an annual earnings period for NIC purposes.

Susan is not a director, so the normal earnings period for NIC in a month will be the interval in which her existing salary is paid.

Assuming NIC rates and thresholds remain the same in 2020/21, if Susan receives an additional salary of £1,000 a month, she will pay Class 1 NIC of £120 (£1,000 x 12%) a month on that additional salary. Her annual NIC bill on the additional salary of £12,000 will be £1,440.

However, if she receives a lump sum bonus of £12,000 in one month (in addition to her normal monthly salary of £720), she will pay NIC on the bonus of £585 ((£3,450 x 12%) + (£8,550 x 2%)).

Paying a bonus instead of a salary reduces Susan’s NIC bill by £855.

Finally, it is important to note that in determining an effective company profit extraction strategy, tax should never be the only consideration. Any profit extraction strategy should be consistent with the wider goals and aims of the company.

Partner note: SI 2001/1004, Reg 11

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Voluntary National Insurance contributions – should you pay?

The payment of National Insurance contributions provides the mechanism by which an individual builds up their entitlement to the state pension and certain contributory benefits. Different classes of contribution provide different benefit entitlements.

Employed earners pay Class 1 contributions where their earnings exceed the lower earnings limit – set at £118 per week (£512 per month, £6,136 per year) for 2019/20. Self-employed earners pay Class 2 and Class 4 contributions, but it is the payment of Class 2 contributions only which provide pension and benefit entitlement. A self-employed earner is liable to pay Class 2 contributions where their earnings from self-employment exceed the small profits threshold, set at £6,365 for 2019/20. Where profits from self-employment are below the small profits threshold, the self-employed earner is not liable to pay Class 2 contributions but is entitled to do so voluntarily. For 2019/20, Class 2 contributions are payable at the rate of £3 per week.

Qualifying year

A year is a qualifying year is contributions have been paid for all 52 weeks of that year. If there are some weeks for which contributions have not been paid, the year is not a qualifying year. However, contributions can be paid voluntarily to make up the shortfall and turn a non-qualifying year into a qualifying year.

How many qualifying years are needed?

An individual needs 35 qualifying years to receive the full single-tier state pension payable to those reaching state pension age on or after 6 April 2016. To receive a reduced single tier state pension, at least 10 qualifying years are needed.

Should voluntary contributions be paid?

Voluntary contributions may be paid to make up the shortfall for a year where Class 1 or Class 2 contributions were not paid for the full 52 weeks or for a year for which there was no liability to either Class 1 or Class 2.

Before paying voluntary contributions, it is necessary to ascertain whether the payment of such contributions would be worthwhile. The starting point is to check your state pension. This can be done online at www.gov.uk/check-state-pension.

If you already have 35 qualifying years (or will do by the time state pension age is reached), there is no benefit in paying voluntary contributions. However, if you have less than 35 years, it may be worthwhile to increase your state pension. Likewise, if by state pension age you will have some qualifying years but less than 10, it may be worthwhile paying sufficient voluntary contributions to secure a minimum pension.

Class 3 contributions

Class 3 contributions are voluntary contributions and can be paid to boost the state pension.

For 2019/20, Class 3 contributions cost £15 per week. Thus, at these rates, to increase the state pension by 1/35th by paying voluntary Class 3 contributions for a year will cost £780. For 2019/20, the single-tier state pension is £168.60 per week, so at 2019/20 rates, each extra qualifying year (up to 35) is worth £4.82 per week.

Class 3 contributions must normally be paid within six years from the end of the tax year to which they relate – although extended time limits in certain cases.

Voluntary Class 2

Where a person is entitled but not liable to pay Class 2 contributions, paying Class 2 contributions voluntary is a cheaper option, at £3 per week for 2019/20 rather than £15 per week.

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Family companies – optimal salary for 2019/20

For personal and family companies it can be beneficial to extract some profits in the form of a salary. Where the individual does not have the 35 qualifying years necessary to qualify for the full single-tier state pension, paying a salary which is equal to or above the lower earnings limit for National Insurance purposes will ensure that the year is a qualifying year.

New tax rates and allowances came into effect from 6 April 2019, applying for the 2019/20 tax year. These have an impact on the optimal salary calculation for family and personal companies. As in previous years, the optimal salary level will depend on whether or not the National Insurance employment allowance is available.

It should be remembered that directors have an annual earnings period for National Insurance purposes.

Employment allowance unavailable

Companies in which the sole employee is also a director are not able to benefit from the employment allowance. This means that most personal companies are not eligible for the allowance. Where the allowance is not available or has been utilised elsewhere, the optimal salary for 2019/20 is equal to the primary and secondary threshold set at £8,632 (equivalent to £719 per month and £166 per week).

At this level, assuming that the director’s personal allowance (set at £12,500) is available, there is no tax or employer’s or employee’s National Insurance to pay. However, as the salary is above the lower earnings limit of £6,136 (£512 per month, £118 per week), it will provide a qualifying year for state pension and contributory benefit purposes.

The salary is deductible in computing the company’s taxable profits for corporation tax purposes, saving corporation tax of 19%.

Employment allowance is available

It is beneficial to pay a salary equal to the personal allowance (assuming that this is not used elsewhere) where the employment allowance (set at £3,000 for 2019/20) is available to shelter the employer’s National Insurance that would otherwise arise to the extent that the salary exceeds £8,632.

Although employee’s National Insurance is payable to the extent that the salary exceeds the primary threshold of £8,632, this is more than offset by the corporation tax deduction on the higher salary.

For 2019/20, a salary equal to the personal allowance of £12,500 exceeds the primary threshold by £3,868. Therefore, employee’s National Insurance of £464.16 (£3,868 @ 12%) is payable on a salary of £12,500. However, as salary payments are deductible for corporation tax purposes, the additional salary of £3,868 saves corporation tax of £734.92 (£3,868 @ 19%). This exceeds the employee’s National Insurance payable by £270.46.

So, if the employment allowance is available, paying a salary equal to the personal allowance of £12,500 allows more profits to be retained (to the tune of £270.46) than paying a salary equal to the primary threshold of £8,632.

If the director has a higher personal allowance, for example, where he or she receives the marriage allowance, the optimal salary is one equal to that higher personal allowance.

Director is under 21

Where the director is under the age of 21, the optimal salary is one equal to the personal allowance of £12,500 (assuming that this is not used elsewhere) regardless of whether the employment allowance is available. No employer National Insurance is payable on the earnings of employees or directors under the age of 21 until their earnings exceeds the upper secondary threshold for under 21’s set at £50,000 for 2019/20. Employee contributions are, however, payable as normal

Any benefit in paying a salary above the personal allowance?

Once the personal allowance is reached it is not worthwhile paying a higher salary as further salary payments will be taxed and the combined tax and National Insurance hit will outweigh the corporation tax savings.

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Is tax payable on tips?

The question of whether tips and gratuities are taxable and subject to National Insurance Contributions (NICs) often results in a lively debate. Broadly, their treatment will depend on how they are paid to the recipient.
Cash tips handed to an employee, or say, left on the table at a restaurant and retained by the employee, are not subject to tax and NICs under PAYE, but the employee is obliged to declare the income to HMRC.
Where HMRC believe that employees in a particular employment are likely to have received tips which have not been declared, they will generally make an estimate of the tips earned on the basis of facts available to them. HMRC often make an adjustment to an employee’s PAYE tax code number to reflect the amount likely to be received during a tax year and the tax and Class 1 NICs due will be collected via the payroll.
By contrast, if an employer passes tips to employees that are either handed to them (or the employees) or left in a common box/plate by customers, the employer must operate PAYE on all payments made. Tips will also be subject to PAYE if they are included in cheque and debit/credit card payments to the employer, or if they pass service charges to employees.
The obligation to operate PAYE remains with the employer where the employer:
• delegates the task of passing the tips or service charges between employees, for example to a head waiter in a restaurant; or
• passes tips/service charges to a tronc (see below) but the tronc is not a tronc for PAYE purposes.
Examples
Marcia, a restaurant owner, passes on all tips paid by credit/debit card to her employees. She has made a payment to her staff and must operate PAYE on these payments as part of the normal payroll.
Franco, also a restaurant owner, allows all cash tips left on tables to be retained in full by his staff. However, to ensure the kitchen staff receive a share, he collects all the cash tips and shares them out to the staff at the end of each day. Franco is involved in the sharing out of the tips and he must therefore include the amounts received as part of the payroll and operate PAYE on them.
Troncs
Where tipping is a usual feature of a business, there is often an organised arrangement for sharing tips amongst employees by a person who is not the employer. Such an arrangement is commonly referred to as a ‘tronc’. The person who distributes money from a tronc is known as a ‘troncmaster’. Where a person accepts and understands the role of troncmaster, he or she may have to operate PAYE on payments made. Broadly, under such arrangements the employer must notify HMRC of the existence of a tronc created and provide HMRC with the troncmaster’s name.
There are no hard and fast rules regarding how a tronc should operate and HMRC will apply the PAYE and NIC rules to the particular circumstances of each tronc. Where payments made from a tronc attract NICs liability, responsibility for calculating the NICs due and making payment to HMRC rests with the employer. If a troncmaster is responsible for operating PAYE on monies passed to the tronc by the employer and has failed to fulfil his or her PAYE obligations, HMRC can direct the employer to operate PAYE on monies passed to the tronc from a specified date.
NICs
Legislation provides that any amount paid to an employee which is a payment ‘of a gratuity’ or is ‘in respect of a gratuity’ will be exempt from NICs if it meets either of the following two conditions:
• it is not paid, directly or indirectly, to the employee by the employer and does not comprise or represent monies previously paid to the employer, for example by customers; or
• it is not allocated, directly or indirectly, to the employee by the employer.
Review business records
It is worthwhile checking that businesses treat tips and gratuities correctly. From time to time HMRC carry out reviews of employers’ records to make sure things are in order for PAYE, NICs and separately for the National Minimum Wage (NMW). Any errors in tax and NICs treatment could prove costly.

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Directors’ NICs – the correct way to pay

The non-cumulative nature for calculating National Insurance Contributions (NICs) makes it possible to manipulate earnings to reduce the overall amount payable by taking advantage of the lower rate of primary Class 1 contributions payable once the upper earnings limit has been reached. For example, an employee who is paid £3,000 each month of the year will pay considerably more in primary contributions than someone who is paid £600 for 11 months and £29,400 for one month, even though their total earnings for the year are the same.

Company directors often have greater scope to influence the time and amount of payments they receive as earnings, which potentially gives them the ability to avoid primary Class 1 contribution liability by astute use of the earnings period rules. For this reason, therefore, special rules exist which provide that a director’s earnings period is a tax year, even if he or she is paid, say, monthly or leaves the company during the year.

The only exception to the above rule is where a director is first appointed during the course of a tax year. Where this happens, the earnings period is the period from the date of appointment to the end of the tax year, measured in weeks. The calculation of the earnings period includes the tax week of appointment, plus all remaining complete weeks in the tax year (i.e. week 53 is ignored for this purpose). This is known as the pro rata earnings period.

Example

Frank is appointed to the board of directors of Widgets Ltd in week 44 of the tax year. The primary threshold and upper earnings limit are calculated by multiplying the weekly values by 9, because the earnings period starts with the week of appointment. This means that in 2018–19, Frank will pay NIC at the main rate of 12% on his director’s earnings between £1,458 (9 × £162) (the primary threshold) and £8,028 (9 × £892) (the upper earnings limit) and at the additional 2% rate on all earnings above £8,028 paid up to 5 April 2019.

The significance of being a company director is that an annual earnings period must be applied for NIC purposes. It is therefore important to be clear as to who the directors of a company actually are. For example, there may be persons within the organisation who are called directors, but for whom that is just an honorary title.

The definition of ‘director’ is wide and extends beyond someone registered as a director with Companies House. For these purposes a director means:

  • in relation to a company whose affairs are managed by a board of directors or similar body, a member of that board or similar body;
  • in relation to a company whose affairs are managed by a single director or similar person, that director or person; and
  • any person in accordance with whose directions or instructions the company’s directors (as defined above) are accustomed to act.

However, a person giving advice in a professional capacity is not treated as a director.

Companies can save time and money by calculating directors’ NIC in a similar way to other employees. Instead of paying very high levels of NIC on a short-term basis, directors who are paid regularly (e.g. directors who have contracts of service with their companies) can spread their contributions evenly throughout the tax year. The earnings period remains an annual earnings period, but contributions are made on account throughout the tax year. A recalculation on an annual basis is performed when the last payment is made and any outstanding National Insurance due is paid at that time.

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