Business

Tax Corner: Salary vs dividend – taking income from your company

What is the most tax efficient way to draw an income from your company?
Feargal McCormack

QUESTION: I run a small company with my son and we are 50:50 owners. We have always taken salaries and bonuses as our reward from the business as our company did not have reserves to pay us dividends.

Now that the company has returned to profitability and the reserves are starting to build up again, can you explain what is the most tax efficient way for us to take income from the company?

Answer: Dividends are the company profits that are given out to shareholders. When a company makes a profit, they're able to distribute a portion of this profit to shareholders. Any part of the profit that is not taken out as dividends is re-invested into the company. If a company does not make a profit, it is not possible to give out dividends.

The reason why many business owners lean towards paying themselves in dividends is because dividends offer you a very tax-efficient solution that is favourable when compared to the tax put onto salaries. Dividends are usually used in conjunction with a salary, with company owners paying salaries just under certain tax brackets and NIC (National Insurance contribution) thresholds and then extracting additional funds through dividends.

In order to pay yourself through dividends, you'll need to have enough retained profits in order to cover the dividend amount you wish to pay. You'll also need to declare the dividend properly and ensure that it is proportionate to shareholdings.

Another reason why people prefer dividends to salaries is because dividends do not attract NIC, as well as the fact that dividends are taxed at a lower rate than salaries. There is also a bracket for tax-free dividend allowances, which is any amount up to £2,000.

What you should keep in mind is that you are only able to take dividends from your post-tax profit. So the amount available to you may have already incurred heavy deductions in the form of corporation tax.

In summary, it is a good idea to make use of both dividends and salaries when extracting money from your business, but it may only be possible to start making use of dividends when your business starts making a substantial profit.

Some of the drawbacks and disadvantages of taking dividends include:

• When taking out dividends, you can only take them out of your profits;

• Dividends are not as reliable as an income, and you may find it difficult to make long-term financial plans;

• There are no benefits such as maternity leave, pensions etc. associated with taking dividends;

• Dividends are paid after tax deductions, unlike salaries (which are in fact tax-deductible);

• If you mistakenly take out a dividend that cannot be covered by your business's profits, you would have taken out a director's loan. And this will need to be repaid; otherwise, you may encounter tax penalties.

As an owner manager and company director, it is advisable that you take a monthly salary even if it's a small one. Taking out a personal allowance of £12,500 (tax year 2020/21) is advisable. When taking at least part of your income as a regular salary has many benefits, which include:

• In the years that you take a salary, you'll be building up to qualify for state pension;

• As you're technically an employee, you'll get benefits such as maternity leave;

• You'll be able to make higher personal contributions to your pension;

• You may find it easier to apply for things like rent contracts, mortgages etc if you can prove that you have a regular monthly salary;

• By taking out a salary you are able to reduce the amount that your business has to pay in corporation tax as a salary is seen as a business expense;

• You're able to take a salary even if your business doesn't make a profit.

The above benefits are definitely substantial and should not be disregarded. Dividends get a good reputation for their tax efficiency, but there are definite advantages to having a regular monthly salary.

That being said, salaries also do come with their drawbacks and disadvantages, some of which include:

• If you take a salary, both you and your business will be subject to NICs

• When taking a salary, you'll be met with higher amounts of income tax.

There is no one answer fits all and the salary dividend discussion needs to be considered for each individual but with careful planning it is possible to construct a mix of salary and dividend that can be tax efficient and leave you with more take home pay.

Feargal McCormack (f.mccormack@pkffpm.com) is managing director of PKF-FPM Accountants (www.pkffpm.com). The advice in this column is specific to the facts surrounding the question posed. Neither the Irish News nor the contributors accept any liability for any direct or indirect loss arising from any reliance placed on replies.

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