Take dividends while you can
Take dividends while you can
For personal and family companies, a tax efficient strategy for extracting profits is to take a small salary and to extract any further funds needed outside the company in the form of dividends. However, while there are no restrictions on taking a salary if the company is making a loss, the same is not true of dividends.
Need for retained profits
Dividends can only be paid out of retained profits (i.e. profits left in the business after corporation tax has been paid).
However, if a company make a loss for a particular year, this does not necessarily preclude the payment of a dividend, as long as the company had retained profits at the start of the year, and the loss has not completely eliminated those profits.
Example
Andrew runs a personal company A Ltd. He prepares accounts to 31 July each year. At 1 August 2020, he had retained profits of £20,000. He expects to make a loss for the year to 31 July 2021 of £5,000. He will have retained profits available after taking account of the predicted loss of £15,000 from which to pay dividends.
Plan ahead
If a company needs funds outside the business and is unsure regards to future profitability, it may be worthwhile taking dividends while there are retained profits available.
Using the figures in the above example, assuming that Andrew has cash available, he may wish to extract all his retained profits as a dividend while he can to benefit from the more favourable tax treatment of dividends. If he makes further losses, his remaining profits may be eliminated, removing the option of taking a dividend.
The dividend will be tax-free to the extent to which it is covered by the dividend allowance (set at £2,000 for 2021/22) and any unused personal allowance. Thereafter, dividends (treated as the top slice of income) are taxed at 7.5% to the extent to which they fall in the basic rate band, at 32.5% to the extent to which they fall in the higher rate band and at 38.1% if they fall in the additional rate band. There is no National Insurance on dividends.
It is prudent to prepare management accounts to show that the company had retained profits at the time at which the dividend was paid, in case of a challenge by HMRC.
No retained profits
In the absence of retained profits, it is not possible to pay a dividend; any payment made that is classed as a dividend, will be made illegally and may be challenged by HMRC and reclassified as a salary or bonus payment, and taxed accordingly.
However, if the company is loss making, but funds are need to meet personal liabilities, it is possible to pay a higher salary or a bonus, even where this increases the amount of the loss. The salary or bonus payment, and any associated employer’s National Insurance, can be deducted in working out the taxable loss, which may be carried back to generate a repayment of corporation tax.
Personal and family companies – Optimal salary for 2021/22
Personal and family companies – Optimal salary for 2021/22
A popular profit extraction strategy for shareholders in personal and family companies is to pay a small salary and to extract further profits as dividends. The optimal salary will depend on whether the employment allowance is available to shelter any employer’s National Insurance liability that may arise.
Preserving pension entitlement
One of the main advantages of paying a small salary is to ensure that the year remains a qualifying year for state pension and contributory benefit purposes. To qualify for a full state pension on retirement, an individual needs 35 qualifying years.
For the year to be a qualifying year, earnings must be at least equal to the lower earnings limit. A director has an annual earnings limit, and for 2021/22, the annual lower earnings limit is set at £6,240. Where the shareholder is not a director, earnings for each earnings period must be at least equal to the lower earnings limit. For 2021/22, the weekly and monthly thresholds are, respectively, £120 and £520.
Contributions are payable by the employee at a notional zero rate on earnings between the lower earnings limit and the primary thresholds. The employee starts paying contributions once earnings exceed the primary threshold.
Optimal salary – Employment allowance is not available
The employment allowance is not available to companies where the sole employee is also a director. This means that personal companies will generally be unable to claim the allowance.
For 2021/22, the primary threshold is set at £9,558 (£184 per week/£797 per month) and the secondary threshold is set at £8,840 (£170 per week, £737 per month).
Although the maximum salary that can be paid without paying any National Insurance is one equal to the secondary threshold of £8,840 for 2021/22, it is beneficial to pay a higher salary equal to the primary threshold of £9,568. Employer’s National Insurance will be payable on the salary to the extent that it exceeds £8,840 at a cost of £100.46 (13.8% (£9,568 – £8,840)), however, this is outweighed by the corporation tax deduction at 19% on the additional salary and the employer’s NIC.
Once the primary threshold is reached, employee contributions are payable at 12%. At this point, the combined National Insurance cost of 25.8% (13.8% + 12%) is more than the corporation tax saving and paying a salary in excess of the primary threshold is not worthwhile.
Thus, where the employment allowance is not available, the optimal salary is equal to the primary threshold for 2021/22 of £9,568 (£184 per week, £797 per month).
Optimal salary – Employment allowance is available In a family company scenario, the employment allowance will be available if there is more than one employee on the payroll. As long as the employment allowance is available to shelter the employer’s National Insurance that would otherwise arise, the optimal salary is one equal to the personal allowance, set at £12,570 for 2021/22. No National Insurance is payable until the primary threshold is reached. Above this level, employee National
Insurance is payable at the rate of 12%. However, the additional salary saves corporation tax at 19%. However, once the personal allowance has been used, tax at 20% is payable as well as employee’s National Insurance of 12%, which exceed the corporation tax deduction of 19%. Thus, where the employment allowance is available, the optimal salary for 2021/22 is one equal to the personal allowance of £12,570 (£242 per week, £1,048 per month).