Salary vs. Dividends

This is probably one of the most common and most important questions asked by a Contractor working via their owner managed Service Company.

At the outset this may seem like a pretty simple question, however like most tax related questions the answer is as complex as the question is simple due to the many factors that need to be taken into account.

Furthermore, the complexity of the answer is matched only by its importance as the wrong advice could lead to thousands of pounds of extra tax.

The issue of how to distribute monies from your company has taken on even greater importance in recent years due to the increases in Taxation and National Insurance for individuals especially with the introduction of the top rate of tax at 50% on income over £150,000 since 6th April 2010.

To help answer the question posed there has to be an understanding of the major differences between salaries and dividends. Don’t worry, you don’t need to understand the differences – that’s your accountant’s job.

The rates of income tax differ between dividends and salaries – this in itself is pretty complex. Your accountant should be able to explain this in easy to understand simple terms.Tax and National Insurance due on salaries is collected through the payroll system (usually monthly). Income Tax due on dividends for higher rate tax payers is usually collected through the self-assessment tax return system, 9 months following the end of the tax year. Salaries are generally subject to National Insurance for both the individual (Employee’s NI) and the company (Employer’s NI). Dividends are not subject to National Insurance.

Salaries are classed as ‘earnings’ for tax relief on Pension Contributions whereas dividends are not.

Salaries paid from your company will usually be classed as a ‘tax allowable’ expense i.e. the amount of the salary plus employer’s NI will reduce the profits of the company and so in turn reduce the amount of Corporation Tax payable by the company. Dividends are paid to shareholders from the profits of the company ‘after’ Corporation Tax has been taken into account i.e. Dividends do not reduce the Corporation Tax payable by the company.

One of the first and possibly the most important thing your accountant should do is help you as a Contractor establish whether you fall ‘inside’ or ‘outside’ of the IR35 legislation. IR35 is an extremely complex subject in itself and so you should choose an experienced specialist contractor accountant to help you determine your status.

Having helped establish your IR35 status the next step should be for your accountant to spend time to get to understand your personal financial requirements. To do this there are some common questions that your accountant would normally ask.

Have you had employment income prior to starting your company in the current tax year What’s the minimum income required by you from the company to ensure you receive sufficient funds to pay your day-to-day living expenses.

Do you have income from other sources e.g. rental income or investment income.

What are your short and long term intentions – Do you have the need to take as much income as possible from the company in a short period of time e.g. to pay off credit card debts or are your circumstances more flexible to enable you to time the distributions from your company in a more tax efficient manner.

Based on the answers to these and other questions your accountant will be able to carry out strategic ‘bespoke’ tax planning and recommend the most tax efficient way for ‘you’ to take income from your company.

As you can see there is no simple ‘one fits all’ formula. Therefore, to ensure you receive the correct tax saving advice you should choose an experienced specialist contractor accountant who has in depth knowledge of the specific taxation regimes in the industry you work in.

By graeme on May 6, 2011

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