The question was put:
I’m still a bit new to this ltd co. thing and I still don’t understand the tax implications of dividends and salary.
My simple understanding is that the salary is drawn up to the maximum personal allowance and the rest in dividends up to the maximum before you get to 40%. You will then pay no tax. If you go over this you pay tax at a lower level (22.5%).
Does the minimum wage have to be paid?
Who pays the 10% tax credit, doesn’t this mean that the company is then paying 31% tax?
What about paying enough NI to draw a state pension?
and the answer:
1 – directors and NMW – you don’t need to pay yourself NMW unless you have a written employment contract between yourself and the company. The former DTI did confirm this when NMW came in as there was confusion.
2 – pension – if you pay yourself less than £90 p/w then there is no NI paid to HMRC but no pension entitlement accrues. Between £90 and £105 you pay NI at 0%, and state benefit entitlement is based on having earnings on which NI is due (including due at 0%), so, as long as the year end P14 is done correctly, you get state benefit / pension entitlement at no cost. Over £105 p/w you pay employers and employees NI. £105 p/w over 52 weeks = the personal allowance level (or it did, I haven’t checked whether the NI threshold has increased following Alistair Darlings revision of personal allowances over the 10% debacle a few weeks ago), so all other things being equal a salary equating to the personal allowance threshold is good.
Another bonus of the 0% NI is that you are deemed to be low paid, so the state make your salary up to c£10,000 pa for the second state pension, pre supposing you are not opted out.
3 – tax credit etc. Directors salary is a charge against company profits and reduces Corporation Tax. Dividends are paid out of the company profit after Corporation Tax and have a tax credit with them. By convention dividends are always referred to in their net amount. Tax credit is at 10%, so a dividend of £9,000 net = £10,000 gross with 10% tax credit.
The £10,000 gross counts as your personal income. To the extent it falls in the Basic Rate tax band, the 10% credit covers the 20% personal tax liability, i.e. the 10% credit is elastic (this anomaly is connected with Gordon Brown shafting pension schemes, charities and your ISA in one of his early budgets). To the extent that the gross dividend goes into the Higher Rate tax band, then the tax rate is 32.5% less 10% credit = 22.5%. (as to the source of 32.5% – when then Corporation Tax rate was 20%, 32.5% on a dividend grossed up at 10%, is the same as 40% on a dividend grossed up at 20%).
As this is a tax credit, not a tax charge as such the tax rate is not 31% – broadly, if you have salary up to PA level, then dividend for the rest, the the combined income tax, corporation tax and NI will be:
£0-personal allowance level = 0%
PA to higher rate = 21% Corporation Tax
over higher rate = 21% CT + 22.5% Income Tax on grossed up dividend (grossed up at 10%)
NB the above rules hold good for most companies, however for our PSC clients we recomend a minimum salary of £8,000 – this does result in some NI being payable, but its perceived that £8,000 is less provocative to HMRC in the IR35 climate than a slary at PA level. For general companies, where IR35 isn’t an issue, we recomend PA level salaries unless there are other commercial reasons. Please bear in mind there are other factors than tax influencing the salary / dividend mix.