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You are the sole director in a company that undertakes some R&D. The annual profit is estimated at £140,000 for the year ended 31 March 2016 before taking into account the director’s remuneration.
You might think that the most tax-efficient remuneration package is £10,600 for 2015/16 to cover the personal allowance and then net dividends of £28,606 to take the director up to the basic rate band. You also need to consider whether the company can make an R&D relief claim and, if it can, how this might affect your decision.
Salary vs Dividends
If the director takes a typical remuneration package, then the net tax and NI savings over taking a salary of £39,206 would be £5,265, assuming the £2,000 employment allowance is available. This saving is made because dividends received within the basic rate band attract no further income tax plus no NI for the director or the company. This more than outweighs the additional corporation tax suffered on profits retained for dividends.
Taking R&D relief into account
From 1 April 2015 the R&D tax credit for SMEs increased from 225% to 230%. There is no R&D uplift on dividends received – only on salary. This means that paying a £39,206 salary would actually result in a saving over taking a small salary and dividends of £1,208.
What about a larger salary? In fact, if the client wanted to take out more than the basic rate band, then the salary may become even more tax efficient. A £70,000 salary would result in net tax/NI due of £1,366 after the R&D relief (assuming there was sufficient profit to offset the CT relief), whereas a salary of £10,600 and net dividends of £59,400 would result in net tax/NI of £5,883 – so the saving by taking a salary over dividends is £4,517.
HMRC will generally not accept 100% of a director’s salary costs within the R&D claim unless it can be clearly demonstrated that the director was exclusively involved in R&D activity.
While dividends don’t qualify as eligible staff costs for R&D claims, company pension contributions do. New pension freedoms make pension contributions a much more attractive option, so you might want to consider this as part of your remuneration package.
If a company makes pension contributions of £40,000 for the director and they spend 60% of their time on R&D, the R&D relief on this will be £55,200 (£40,000 x 60% x 230%). This means that the overall CT saving on the pension contribution will be £14,240 (((£40,000 x 40%) + £55,200) x 20%). As there’s no NI due on pension contributions, this is an even more efficient option than taking additional salary.
Get the best deal for yourself
For advice on the best split between salary and dividends or help with setting up a limited company and registering for VAT, please contact Alterledger.
The Growth and Infrastructure Act 2013 comes into force on 1st September 2013 and Section 31 makes changes to the Employment Rights Act 1996 inserting section 205A Employee Shareholders.
205A Employee shareholders(1) An individual who is or becomes an employee of a company is an “employee shareholder” if—(a) the company and the individual agree that the individual is to be an employee shareholder,(b) in consideration of that agreement, the company issues or allots to the individual fully paid up shares in the company, or procures the issue or allotment to the individual of fully paid up shares in its parent undertaking, which have a value, on the day of issue or allotment, of no less than £2,000,(c) the company gives the individual a written statement of the particulars of the status of employee shareholder and of the rights which attach to the shares referred to in paragraph (b) (“the employee shares”) (see subsection (5)), and (d) the individual gives no consideration other than by entering into the agreement.(2) An employee who is an employee shareholder does not have—(a) the right to make an application under section 63D (request to undertake study or training),(b) the right to make an application under section 80F (request for flexible working),(c) the right under section 94 not to be unfairly dismissed, or(d) the right under section 135 to a redundancy payment.
Giving up employment rights might not sound like a good idea for employees but there are tax advantages for both the employee and employer:
- Dividends are not subject to PAYE or National Insurance
- Dividends would not be used as Pay in Auto Enrolment
- Capital Gains Tax Allowances should make most gains tax free
- The employer will benefit from cost savings on the sacrificed employment rights
It can be illegal to pay dividends if:
1. There are insufficient retained profits to cover the dividend payments
2. Dividend payments may be illegal if the relevant paperwork has not been completed
- Board Minutes – which must be kept for 10 years http://www.companieshouse.gov.uk/about/gbhtml/gp3.shtml#ch4
- Dividend Vouchers
You can download free templates from
HMRC are increasingly contending dividends and arguing that they are in reality earnings under the s62 ITEPA 2003 (salary sacrifice) rules and to persuade them otherwise needs proof that a set procedure for the declaration of dividends has been followed.
An example of a board minute is as follows:
Minutes of a meeting of directors of bloggs limited Held at 14 the road, london, ir3 5nl On 31 march 2005
Present: J Bloggs – Director
It was resolved that the company pay a dividend of £9,000 per £1 ordinary share on 31 March 2005 to the shareholders registered on 31 March 2005.
J Bloggs – Director
Companies pay you dividends out of profits on which they have already paid – or are due to pay – tax. The tax credit takes account of this and is available to the shareholder to offset against any Income Tax that may be due on their ‘dividend income’.
When adding up your overall taxable income you need to include the sum of the dividend(s) received and the tax credit(s). This income is called your ‘dividend income’.
The dividend you are paid represents 90 per cent of your ‘dividend income’. The remaining 10 per cent of the dividend income is made up of the tax credit. Put another way, the tax credit represents 10 per cent of the ‘dividend income’.
Dividend tax rates 2013-14
|Dividend income in relation to the basic rate or higher rate tax bands||Tax rate applied after deduction of Personal Allowance and any Blind Person’s Allowance|
|Dividend income at or below the £32,010 basic rate tax limit||10%|
|Dividend income at or below the £150,000 higher rate tax limit||32.5%|
|Dividend income above the higher rate tax limit||37.5%|
So the 10% tax credit offsets the 10% basic rate savings tax
Dividends are not subject to National Insurance.
Can you claim the tax credit if you don’t normally pay tax?
No. You can’t claim the 10 per cent tax credit, even if your taxable income is less than your Personal Allowance and you don’t pay tax. This is because Income Tax hasn’t been deducted from the dividend paid to you – you have simply been given a 10 per cent credit against any Income Tax due.
Declaring dividend income on your Self Assessment tax return
If you normally complete a tax return you’ll need to show the dividend income on it. See income boxes 3 and 4 http://www.hmrc.gov.uk/forms/sa100.pdf
If you don’’t complete a tax return, but you have higher rate of tax to pay on your dividend income, you should contact HMRC.
This is a question I am asked often, normally in casual conversation at social gatherings, and one of the reasons I try not to let people know that I’m an accountant; I can only imagine how much worse it must be for doctors …..
Without knowing precise details of a business operation, it is difficult to respond to such questions with any great certainty, but there are some ‘rules of thumb’ we can employ to which might lead us to a reasonable conclusion.
But first, it might be worth taking a brief look at what options exist and what the main features of each are, and in doing so I am deliberately excluding Public Limited Companies (“plc”) which is the legal form of a majority of large businesses which shares are traded on various stock exchanges.
Private Limited Liability Company (“Limited”)
A limited company is formed, or ‘incorporated’, by an individual or group of individuals wishing to carry out a particular business. Most importantly, once incorporated, the company is a separate legal ‘person’ from its owner(s); it exists in its own right, pays its own taxes, can sue or be sued, and so on.
A Memorandum of Association is drawn up which states why the company has been incorporated and what business it is allowed to undertake, and Articles of Association set out the basic rules by which the company should be run, such as what happens when one of the owners wishes to sell their share of the company.
The owner(s), often referred to as ‘members’, will each own a share of the company (hence the alternative term ‘shareholder’), their liabilities for the debts of the company are generally limited to whatever they have paid for that share of the company, and their personal assets are therefore protected from attack by creditors of the company.
The owner(s) will appoint one or more ‘directors’ to run the company for them (i.e. to ‘act for the company’ so that it effectively operates through them). The directors may be paid a fee and/ or expenses for attending meetings and generally acting for the company.
In turn the director(s) may employ staff to work within the company and may themselves work within the company, and this is often referred to as an ‘executive’ directorship, as distinct from a ‘non-executive’ directorship where the director may attend board meetings only and vote on various issues concerning the running of the company.
In law, executive and non-executive directors are all simply directors and have the same authority and responsibilities for the running of the company, but executive directors will have additional authority and responsibilities in terms of running the business of the company as set out in their service contract or contract of employment, and for which they will normally be paid a wage or salary.
So an individual may be a shareholder, and/ or a director, and/ or an employee (executive) of the company, but they are three very distinct roles and whenever an individual acts ‘on behalf’ of the company, or the company’s business, he or she needs to be clear which ‘hat’ they are wearing so that these roles do not become confused.
This distinction is particularly important when considering payments made between the company, its director(s), its owner(s), and its employee(s) so for clarity:
The company itself (not the owners), is liable for ‘Corporation Tax’ on the profits it makes and currently there is a Small Companies Rate of 20% on profits of up to £300,000 in a year, and thereafter a Main rate of Corporation Tax of 23%, but these change periodically so please check the current rates at http://www.hmrc.gov.uk/rates/corp.htm.
The company pays its employee(s) for the work they do and such payments are legitimate business costs and can be set against profits thereby reducing any corporation tax due; conversely these payments are income for the employee(s) on which they will need to pay tax and other deductions (the company is required by law to act as tax collector on behalf of HM Revenue and Customs making deductions at source under “Pay As You Earn”).
Any profits made by the company, after corporation tax has been paid, can be shared out between the owner(s), normally pro-rata to their shareholding, and this is termed a ‘dividend’ payment, and because corporation tax has already been paid in respect of these profits, the dividend carries a tax credit (currently 10%) which the owner(s) can effectively claim back as tax already paid against any other tax they may need to pay.
Tax on such dividend income is at a lower rate to normal earned income (I don’t know why but have always presumed in recognition of the risk the owner(s) have taken in investing in their company), and so currently if the owner is a basic rate taxpayer, the tax credit fully offsets the tax due on the dividend income, and so there is no further tax to pay on it; again these rates change from time-to-time so please check the current rates at http://www.hmrc.gov.uk/rates/it.htm.
One particular downside of tax regime as applied to limited companies to be aware of is that where the company provides a car for its employees, whether executive directors or other staff, this is deemed to be in lieu of wages or salary, and regardless of whether the car is a necessary tool of the trade as it is for many small business owner/ directors, or individuals with for example sales roles. And depending upon the cost of the particular car and whether the company also provides fuel, the tax assessment can be quite harsh – see http://www.hmrc.gov.uk/calcs/cars.htm. This tax regime also applies to commercial vehicles provided by the company though the tax assessment is currently less harsh.
Finally, a company is required to disclose details of its operation including a ‘filing’ of its annual accounts at Companies House where other individuals and organisations can view these. For many small businesses this will be an abbreviated version of what is prepared and submitted to HM Revenue and Customs being limited to an end of year balance sheet only, rather than the full profit and loss account required by HMRC.
When an individual ‘starts up in business for themselves’ then they are termed a ‘sole trader’, and unlike the limited company, which is a separate legal entity from its owner(s), the sole trader and his or her business are one and the same.
The most important consequence of this is that generally, all the personal assets of the sole trader are at risk from attack by creditors should the business fail or find itself in difficulty.
The main advantages of this trading form is its simplicity and the lack of disclosure of the businesses financial affairs at Companies House (there is little real saving in record keeping or accounts preparation since the accounts to be prepared each year for HMRC are little different to those required for a limited company).
The sole trader is liable for tax and national insurance on the profits made by their business and any salary or wage which they take out of the business is not allowable against these profits in calculation the tax and NI due.
Conversely such payments, which are termed ‘drawings’, are essentially a distribution of the profits made and are not assessable for tax since they have already been taxed originally as profits. Note that monies introduced into the business by the sole trader are termed ‘capital introduced’, profits made add to this capital, and drawings (including tax paid) taken reduce it, so if the business is not making profits then any drawings simply deplete the capital (and cash reserves) of the business
Further, there is no saving in payroll administration once the sole trader takes on staff since as with a company the sole trader pays its employee(s) for the work they do and whilst such payments are legitimate business costs thereby reducing any tax due from the owner in respect of his/ her business profits, these payments are of course, income for the employee(s) on which they will need to pay tax and other deductions (the sole trader is required by law to act as tax collector on behalf of HM Revenue and Customs making deductions at source under “Pay As You Earn”).
Equally, whereas the sole trader can generally charge the business proportion of all running costs of a vehicle to profits, thus reducing their tax bill, any vehicle provided to employees fall under the same regulations as those for company employees.
The sole trader will generally have to make advance payments of tax, essentially a deposit or ‘on account’ payment on the current year’s anticipated profits, and which will be estimated based on the previous year’s profit, so there is a real danger in a poor trading year of substantially overpaying tax when cashflow can least afford it, albeit the overpayment can be refunded once the true trading position becomes clear.
Finally, consideration should be given to timing when starting up the business in relation to the tax year since HMRC will assess profits made by ‘basis period’ – see http://www.hmrc.gov.uk/manuals/bimmanual/BIM71010.htm which may mean that any profit may be the basis for assessment of tax in more than one tax year.
There are several types of partnership but generally what is referred to when speaking of ‘a partnership’ is a Partnership within the meaning of the Partnership Act 1890 – see http://www.legislation.gov.uk/ukpga/Vict/53-54/39/contents
Such partnerships are formed by two or more individuals wishing to carry out a particular business, and they may or may not formally write down any rules and regulations for running the partnership such as who will receive what share of any profits.
If such partnerships are thought of as a ‘group of sole traders’, then much of what is set out in the above section can be said to apply equally here. However there are two variations on this basic theme:
Limited Partnership regulated by the Limited Partnership Act 1907 see – http://www.legislation.gov.uk/ukpga/Edw7/7/24/contents – in which at least one of the partners restricts their liability for the debts and obligations of the firm to a pre-determined sum, instead of bearing unlimited liability as a partner normally does.
The partnership must consist of at least one general partner who manages the business and bears unlimited liability to creditors, and at least one limited partner (who may not take part in the management of the firm’s business). The limited partner must contribute a specified amount of capital on joining the firm, which they cannot withdraw as long as they remain a limited partner, but cannot be made to bear any liability to creditors or their fellow partner(s) in excess of that amount plus any undrawn profits.
A limited partnership must register with the Registrar of Limited Partnerships in London or Edinburgh as appropriate and failure to register deprives it of its limited liability status.
Limited Liability Partnership (“LLP”) – governed by the Limited Liability Partnership Act 2000 – see http://www.legislation.gov.uk/ukpga/2000/12/contents – an alternative corporate business vehicle that gives the benefits of limited liability but allows its members the flexibility of organising their internal structure as a traditional partnership.
It is a separate legal entity and, while the LLP itself will be liable for the full extent of its assets, the liability of the partners will be limited.
Any new or existing firm of two or more persons can incorporate as an LLP, which must be registered at Companies House and for which the registration process and cost of registration are similar to that for a limited company.
Disclosure requirements are also similar to those of a company since LLPs are required to provide financial information equivalent to that of companies, including the filing of annual accounts, an annual return, and notification of any changes to the LLP’s membership, members names & residential addresses, and change to their Registered Office Address.
However, a LLP is taxed as a partnership, the partners providing capital and sharing any profits (the LLP will normally be regarded as transparent for tax purposes and each member will be assessed to tax on their share of the LLP’s income or gains as if they were partners of a general partnership governed by the Partnership Act 1890; partners will be liable to pay Class 2 and Class 4 NIC.
The trading form of the business, as we can see from the above, can take a variety of forms, and in answer to the question originally posed it is useful to consider the response to the following points:
1. if the business is relatively simple with little by way of borrowings from banks and other lenders, or credit to customers, or from suppliers, then a simple sole trader (or partnership for more than one individual) may be most appropriate;
2. where protection of personal assets and therefore limited liability is an important consideration then incorporation as a private limited liability company (or change to LLP status for an existing partnership) should be seriously considered (but be aware that this will still not protect the owner/ director if personal guarantees have been given to lenders in lieu of security for their loan);
3. if the business runs expensive motor cars then there could be a significant additional tax liability arising on incorporation of the business which might outweigh other advantages (if limited liability is desired then it may be worthwhile considering removing the vehicles from the business and running as privately owned vehicles, and charging the company per mile for use on company business post incorporation);
4. there is some flexibility on when and how much tax is paid overall for a limited liability company, for example, profits and therefore cash could be retained in the company, say for investment, and distributed subsequently as dividends when cashflow permits (as a sole trader or partnership there is less flexibility in that tax is due on profits irrespective of whether cashflow has permitted the profits to have been taken as drawings) so if such flexibility is important then again incorporation should be considered;
5. save for at business start up, tax is normally paid earlier by sole traders and partners, so there may be cashflow advantages in incorporating once the business has been established.
The above is of course, a very generalised assessment and having given due consideration to these generalities, I would advise that you then talk over the particular requirements of your particular business with your accountant and/ or business adviser before making a final decision.
As ever in life, few alternatives are ‘all good’ or ‘all bad’, and you will need to weight up the pros and cons as they apply to your particular circumstances and settle on the best overall option for you.
Paul Driscoll is a Chartered Management Accountant, a director of Central Accounting Limited, Cura Business Consulting Limited, Hudman Limited, and AJ Tensile Fabrications Limited, and is a board level adviser to a variety of other businesses.