Tax-Efficient Profit Extraction Using Salary and Dividends in the UK
Overview
Company: XYZ Ltd.
Owner: Sarah, the sole director and 100% shareholder.
Annual Profit: £120,000 (before any salary or dividends are paid).
Current Personal Allowance (2023/24): £12,570.
National Insurance Contributions (NICs) Thresholds:
- Primary Threshold: £12,570 (Employee NICs start above this).
- Secondary Threshold: £9,100 (Employer NICs start above this).
- NIC Rates: Employee NICs at 12% up to £50,270, 2% thereafter; Employer NICs at 13.8%.
Objective: Sarah aims to extract profits in the most tax-efficient manner, considering both salary and dividends.
Strategy
Sarah decides to adopt a mixed approach, using both a salary and dividends to extract profits efficiently. The key considerations are:
Salary:
Set at a level that is just above the NIC secondary threshold, ensuring that it qualifies as a business expense and reduces the corporation tax liability while minimizing NICs.
Dividends:
Take dividends from the remaining profits after paying the salary, ensuring Sarah maximizes her personal allowance and uses the lower dividend tax rates.
Step 1: Determine Salary
Sarah decides to pay herself a salary of £12,570, which matches her personal allowance. This approach means:
Corporation Tax Impact:
- The salary is a deductible expense, so it reduces the company’s taxable profit.
- Taxable Profit = £120,000 – £12,570 = £107,430
Employer NICs:
- Since the salary is above the secondary threshold (£9,100), employer NICs are payable on the amount above this threshold.
- NICs Payable = (£12,570 – £9,100) * 13.8% = £479.46.
Employee NICs:
- As the salary is equal to the primary threshold, no employee NICs are due.
Step 2: Calculate Corporation Tax
The corporation tax rate is 19%. After deducting Sarah’s salary and employer NICs, the company’s taxable profit is:
- Taxable Profit: £107,430 – £479.46 = £106,950.54
- Corporation Tax: £106,950.54 * 19% = £20,320.60
Step 3: Determine Available Dividends
After paying corporation tax, the remaining profit can be distributed as dividends:
- Post-Tax Profit: £106,950.54 – £20,320.60 = £86,629.94
Step 4: Dividend Tax Calculation
Sarah can take dividends up to the available post-tax profit. Dividend tax rates for 2023/24 are:
- 0% on the first £1,000 (dividend allowance).
- 75% within the basic rate band (up to £50,270 after salary).
- 75% within the higher rate band (above £50,270).
Basic Rate Dividend Tax:
- Sarah’s taxable income after salary is £86,629.94 – £12,570 = £74,059.94.
- First £1,000 is tax-free (dividend allowance).
- £37,700 (basic rate band) * 8.75% = £3,298.75.
Higher Rate Dividend Tax:
- Remaining dividends: £74,059.94 – £37,700 – £1,000 = £35,359.94.
- £35,359.94 * 33.75% = £11,928.98.
Total Dividend Tax: £3,298.75 + £11,928.98 = £15,227.73.
Step 5: Calculate Sarah’s Total Net Income
- Net Salary: £12,570 (no income tax or NICs due).
- Net Dividends: £86,629.94 – £15,227.73 = £71,402.21.
- Total Net Income: £12,570 (salary) + £71,402.21 (dividends) = £83,972.21.
Step 6: Total Tax and NICs Liability
- Corporation Tax: £20,320.60.
- Employer NICs: £479.46.
- Dividend Tax: £15,227.73.
- Total Tax and NICs: £36,027.79
Comparison and Analysis
Efficiency of Profit Extraction:
- By setting the salary at the personal allowance threshold, Sarah avoids paying income tax and employee NICs on her salary.
- Dividends are taxed at a lower rate compared to salary, and there are no NICs on dividends, making this method more tax efficient.
Total Tax Paid:
- The combination of salary and dividends reduces the overall tax burden compared to taking the entire amount as salary, where higher NICs and income tax rates would apply.
Key Considerations:
- This strategy takes full advantage of the personal allowance, NIC thresholds, and dividend tax rates.
- It also ensures that the company can still pay tax-deductible expenses while minimizing the total tax liability.
Conclusion
Using a mixed strategy of a minimal salary and maximizing dividends is generally the most tax-efficient method for profit extraction for owner-directors in the UK. This approach allows Sarah to extract £83,972.21 from the company while minimizing her total tax and NICs liability to £36,027.79. This strategy balances the benefits of reducing corporation tax while taking advantage of the lower tax rates on dividends.