Salaries versus Dividends

One key question asked by contractors and freelancers when trading as a limited company, is, “how is best to extract income from the company?”. It is important to understand the differences between drawing money as salary and drawing money as dividends, and the tax treatment of each.

Which method is best for tax efficiency?

• If you extract profits as dividend and you do not have any other income, you will waste your personal allowance, because tax credits on a dividend cannot be repaid. In this case, it is worthwhile paying a salary to cover at least some of your available personal allowance.

• Even if you take most of your profits as dividend, it is still advisable to draw a small salary to preserve entitlement to state pension and other benefits.

• Salaries can be allocated to directors at different rates, whereas a shareholder is entitled to a dividend at a fixed rate for each share. Non-working shareholders could receive dividends at the same rate as those who work. It is possible to solve this problem by creating different classes of share, with different dividend entitlements. HMRC may challenge this arrangement, if it thinks it is wholly or mainly for avoiding tax.

• Salaries can be paid even when the company is making a loss, whereas dividends can only be paid out of profits for the year, or any undistributed profits from previous years.

• You will not have to operate PAYE on dividend payments, but it is essential that the correct procedure is followed.

• Paying a salary, rather than a dividend, reduces Corporation Tax, particularly for companies that do not pay tax at the small companies’ rate (ie £300,000).

• There are different cashflow implications. Tax and National Insurance is deducted from salaries on a monthly basis. Dividends must be paid within nine months of the company year-end. Any extra income tax on dividends is due by the following 31 January, and payments on account may be required.

There are numerous factors that should be taken into account when deciding how to extract profits from the business, and in practice a mixture of salary and dividend is probably the most suitable course of action.