Salary or Dividend? Tax Planning Guide

By Carl Bayley BSc ACA

"Salary or Dividend?" - it's been one of the major tax planning questions facing company owners for as long as most of us can remember. Over the years, the answer has changed back and forth many times as successive Chancellors of the Exchequer have tinkered with the tax system, but the question itself remains as important as ever.

Most company owners need to extract profits from their company to support themselves and their families and perhaps also to fund private investments elsewhere. It is therefore absolutely vital for the company owner to keep abreast of the changing answer to the 'Salary or Dividend' question, as the tax arising under the two methods can be significantly different and the wrong decision can cost thousands of pounds!

Existing Salary

Most company owner/directors will already be paying themselves sufficient salary to take them into higher rate Income Tax. There are a number of reasons why the owner director may be doing this, but we'll just take it as read for the moment.

Let us now suppose that there is an additional £100,000 available in the company which the owner/director wishes to extract.

Dividend

After 31st March 2006, taking this extra sum as a dividend has no effect on the company's Corporation Tax position. (Previously, small companies with profits under £50,000 suffered an additional tax charge when paying dividends.)

The director will, however, suffer £25,000 in Income Tax on the dividend, leaving him with a net sum of £75,000.

Bonus

If the company decides to use the £100,000 to fund a bonus, it will generally obtain Corporation Tax relief on this payment. The £100,000 can therefore be considered to be a net sum after tax relief. The gross sum before tax relief will depend on the company's marginal rate of Corporation Tax. A company's marginal rate is the effective rate applying to its top slice of income and thus also represents the rate of relief available on any additional expense, including our bonus.

The table below sets out the three possible marginal rates applying from 1st April 2006, together with the resultant gross sum for our bonus. (The same rates applied before that date except in the case of companies with profits under £50,000.)

Annual profit up to £300,000: 19% (Gross bonus - £123,457)

Annual profit £300,000 - £1,500,000: 32.75% (Gross bonus - £148,699)

Annual profit over £1,500,000: 30% (Gross bonus - £142,857)

Before paying its 'gross bonus', however, the company will need to account for employer's national insurance at 12.8%. In the case of our 'middle' company with profits of £300,000 to £1,500,000, this will mean that only a net £131,825 is available to pay out, as the remaining £16,874 is taken up by the 12.8% national insurance bill.

The owner/director will also suffer Income Tax at 40% and employee's national insurance at 1% on the bonus received. This produces total additional tax costs of £54,048, leaving a net sum of £77,777 in the director's hands.

Nevertheless, our 'middle' company director is still £2,777 better off than if he or she had taken a dividend meaning that a bonus is generally better for directors of companies with annual profits of £300,000 to £1,500,000 who are already higher rate taxpayers.

Do the same sums for the 'small' company (profits up to £300,000) and you'll find that a dividend is better by £9,426 and for a 'large' company with profits over £1,500,000, dividends win again but in a much closer contest with a margin of just £279.

In Summary

In summary, taking our three company profit brackets as set out above, it's dividends for a small company, bonuses for a medium-sized company and it's just about dividends again for a large company.

Bonuses do, of course, have a significant cashflow disadvantage as PAYE and NIC's will be due almost immediately whereas the Corporation Tax relief will not be obtained for some time. Some owner/directors of medium-sized companies may feel this is enough to over-ride the relatively small overall advantage of a bonus.

All this assumes that the director already takes a reasonable salary. If not, the equations change drastically and there really isn't room to cover every possible scenario here.

Before paying either bonus or dividend, however, it's always worth remembering that the long-term capital gains tax rate available on your company shares is now often just 10%, meaning that retaining the funds in the company is often preferable where practical to do so.