With the start of a new tax year comes a change in the rates and thresholds for PAYE and NIC. This article will explain the optimal salary for a personal and family company and how to use dividends to ensure tax efficiency.
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 (you do need to remember to make the regular monthly or quarterly payments to HMRC though).
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 more than 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. If 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).
Use the dividend allowance
Once an optimal salary has been paid, it is tax-efficient to extract further profits as dividends. Making family members shareholders allows dividends to be paid to family members.
Where dividends have not been paid, consideration should be given to declaring dividends to use up the dividend allowance to prevent it from being wasted.
All taxpayers are entitled to a dividend allowance, set at £2,000 for 2021/22. Dividends sheltered by the allowance are taxed at a zero rate. Dividends are taxed at the top slice of income and the dividends covered by the allowance use up part of the tax band in which they fall.
Where any of the personal allowance remains available (as will be the case if the director’s only other income is a salary equal to the primary threshold), dividends sheltered by the remaining personal allowance will also be tax-free.
Dividends are paid out of retained earnings and have already suffered corporation tax. A company can only pay dividends to the extent that it has sufficient retained profits. Dividends paid to the level of the dividend allowance and any unused personal allowance can be paid without triggering a further tax liability.
Extract further profits
Having paid the optimal salary and utilised the dividend and personal allowance, further profits that are extracted will trigger an income tax liability. Beyond the optimal salary level, the lower dividend tax rates (7.5%, 32.5% and 38.1%) and lack of national insurance make it more tax-efficient to extract further profits as dividends, even though profits paid out as dividends have already suffered a corporation tax liability.
When deciding whether to pay a dividend either before the tax year or after the company’s year-end, consideration should be given to whether the funds are needed outside the company. Where funds are needed by shareholders, it is better to extract them as dividends; if they are not required, it may be more tax-efficient to leave them in the company (particularly where a dividend would be taxable at 32.5% or 38.1%).
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