One of the perceived major benefits of incorporation is the ability to extract profits by way of dividends. The main advantage is in National Insurance savings as no NICs are payable on dividends, whereas a salary payment would attract employee NICs of 12% or 2% and employer NICs of 13.8% (2012/13 figures).
Dividends also come with an associated tax credit (the dividend is deemed to be paid net of the 10% tax credit). Dividends are taxed at a rate of 10% up to the basic rate limit, which is matched by the tax credit, so no additional tax is payable on dividends until the basic rate limit is exceeded. The dividend higher tax rate is 32.5% and the dividend additional tax rate is 42.5%. A payment of salary will attract tax at the taxpayer’s marginal rate of income tax (20%, 40% or 50% as appropriate).
However, unlike salary payments and employer NICs, dividends are not deductible when calculating corporation tax profits and must be paid out of after-tax profits.
A dividend can only be paid if there are sufficient retained profits. In addition, various company law requirements must be met.
It is not simply a case that dividends are always best, although in many cases taking dividends will result in less tax and National Insurance than taking remuneration.
However, the best result will depend on the circumstances as the decision whether to take remuneration or dividends will depend on the interaction of various factors – respective rates of income tax, corporation tax and National Insurance contributions, any other income that the taxpayer has and whether the company has sufficient retained profits.
To decide whether to extract profits by way of a dividend or a salary, crunch the numbers first (rates applying for 2012/13 and the financial year 2012 are used in the example).
Paul is the director and sole shareholder of a one-man company. He has profits of £20,000 and wants to know whether to extract them by way of a salary or a dividend. It is assumed that he has received a small salary equal to his personal allowance.
Less Employer’s NIC (£2,425)
Available to pay as salary £17,575
Less Income Tax @ 20% (£3,515)
Less NIC @ 12% (£2,109)
Retained by shareholder £11,951
There is no corporation tax to pay as taxable profits are reduced to nil after deducting salary of £17,545 and employer NIC of £2,425.
Less Corporation Tax @ 20% (£4,000)
Distributed as a dividend £16,000
Income Tax £ —
Retained by shareholder £16,000
The gross dividend (£16,000 x 100/90) of £17,777 does not take the shareholder’s income above the basic rate limit so no additional tax is payable on the dividends. The tax on the dividend (£1,777) is fully matched by the associated tax credit.
In this case, dividends are clearly more beneficial than a salary. The shareholder retains £16,000 of the profit by taking a dividend and only £11,951 if a salary is taken.