Using a payroll to save dividend tax
From 6 April 2016, a new tax on dividends was introduced.
This means that anyone with dividends in excess of £5,000 per year will pay an extra 7.5% tax on their dividends over the £5,000 dividend allowance. This applies to basic rate, higher rate and additional rate taxpayers.
The consequence is that everyone, no matter what their marginal rate of tax, can receive £5,000 in dividends completely tax free.
This article is targeted at those small businesses, run through limited companies, with a second income and who may not have considered running a payroll for their business.
Why run a payroll for a small company?
There are many reasons to run a payroll for a small limited company business, especially if the business owner is not already included on another payroll.
The advantages can include reducing the company profits, and therefore savings Corporation Tax, but avoid paying any income tax personally, as the salary is covered by the income tax personal allowance of the business owner.
Another advantage is that by paying a small salary (over £5,824 in 2016-17) the recipient receives a Qualifying Year towards their Flat Rate State Pension. Each Qualifying Year is worth £237 pa (at 2017-18 rates) for the rest of your life. i.e. full flat rate pension is £159.55 pw = £8,297 pa. Each Qualifying Year gives you 1/35th of £8,297 i.e. £237 pa.
Why run a payroll for my small part-time limited company when I’m already included on another payroll through my main full time job?
There are lots of small limited companies run by part-time, as well as full-time, business people. The part-time business owner may already have a full time job and receive a salary from it. They therefore do not consider running another payroll for their small part-time self-employment run through a limited company.
So why should you run a payroll, even for you as a small one- person company with a second income? The answer is to save dividend tax.
Assuming that your profits are not insignificant, e.g. £15,000 plus, you may have set-up a limited company to save tax and National Insurance compared to trading as a sole trader or partnership.
The surplus profit, after paying Corporation Tax, is then drawn as a dividend. This has been established good practice for many years; at least until the dividend tax was introduced on 6 April 2016.
An example showing the tax savings
The example that follows assumes that you have already fully used your personal allowance through other taxable income e.g. your main employment and have used up your £5,000 dividend allowance. Therefore, all salary drawn from your ‘second-income’ limited company payroll will be taxed at the basic rate of income tax of 20%. This is because as all your tax code (tax free personal allowance) has been allocated to your main job, you have to pay income tax on all the income drawn from the second salary.
Let us say that you have earned some extra company profits of £8,064 and you pay that all out as a dividend. You would pay 20% Corporation Tax on the extra profits i.e. £1,613. This would leave £6,451 in post-tax profits. You then take that out of the company as a dividend and therefore pay dividend tax at 7.5% i.e. £484. You therefore receive £5,967 after all taxes.
Alternatively, let’s assume that you pay a salary equal to the extra profits generated of £8,064. You have no company profit and therefore no Corporation Tax to pay. The company will pay PAYE of 20% on the £8,064 salary i.e. tax of £1,613. Your net take home salary is £6,451 i.e. the same as your dividend. Your gross salary has already been taxed at 20% (the £1,613 PAYE) and no further tax is payable (assuming you are not a higher rate tax payer). No dividend tax is payable as you have not paid a dividend. You therefore receive £6,451 after all taxes.
You are therefore £484 better off paying a salary, equal to the profits, than paying a dividend.
More tax savings
This example still applies if your ‘second-income’ limited company is making substantial profits and you have already taken at least £5,000 in dividends, thereby using the full £5,000 dividend allowance. You can save £484 per person put on the payroll. So, with a husband and wife or two partners, £968 in tax can be saved on £16,128 of profits.
You may think, ‘Why do I not take more as salary if it is more tax efficient then dividends?’ The reason is that once your salary increases above £8,064, you have to pay 12% employee National Insurance and 13.8% employer’s National Insurance; only to save 20% Corporation Tax on the extra salary.
Unlike income tax, income from more than one job is not aggregated for National Insurance purposes. Therefore, £8,064 can be taken per employment without paying any National Insurance. You could therefore, in theory, have a company for each day of the week. You could therefore avoid paying £8,322 of National Insurance on £40,320 of income. This rule may change in the future.
Any PAYE income tax that you pay on the gross salary, through the business at 20%, will save the same amount in Corporation Tax at 20%. Taking a salary is therefore tax neutral. By taking a salary to withdraw profits you avoid paying dividend tax on the same amount if it is drawn as a salary.
For other ideas to reduce the new dividend tax see our article The new Dividend Tax and how to reduce it. Also see our article on Tax efficient profits extraction from your limited company.