A limited company is a legal ‘person’ in its own right, which means that it’s financially independent of its directors and shareholders. In additional to being responsible for its own debts and liabilities, the money that a company receives belongs to the business, not the company’s owners. As a result, certain rules and restrictions apply to the way in which you can withdraw money and pay yourself through a limited company.
The most common and tax-efficient form of remuneration is a combination of a director’s salary and dividend payments from shares. Most small company owners are both directors and shareholders.
Directors are classed as employees; shareholders are classed as investors. This means that any person who is a director and shareholder of their own company can pay themselves a regular director’s salary and top up their income with dividend payments.
Director’s salary
Directors’ salaries are an allowable business expense, so they are paid before Corporation Tax is calculated on company profits. To pay yourself a director’s salary, you will need to register your company as an employer and operate PAYE (Pay As You Earn) as part of your payroll.
You can arrange for an annual salary to be paid through PAYE at regular intervals, such as weekly, fortnightly, or monthly. The company will then deduct Income Tax and Class 1 National Insurance contributions (NICs) from your earnings, which HMRC will collect through PAYE. The company will also pay Employers’ National Insurance on your salary.
Some directors choose to keep their salaries below the Primary Threshold (PT) for NICs, which is £183/week (£9,516/year) for the 2020-21 tax year. This results in no Income Tax or Class 1 NICs being deducted from the salary.
Another popular option is to take a salary above the PT but below the tax-free Personal Allowance, which is currently £12,500. This results in no Income Tax deductions but a small amount of NI, ensuring the director is making eligible contributions toward his or her State Pension.
You can, however, pay yourself any size of salary that you wish, provided the company can afford it. Indeed, many directors feel that it is more ethical to pay themselves a larger salary and take smaller dividends only when the company has significant profits.
Paying Income Tax and NICs on a director’s salary
If you live in England, Wales, or Northern Ireland, you will pay the following rates of Income Tax on your director’s salary:
- Personal Allowance rate: 0% on annual income up to £12,500
- Basic rate: 20% between £12,501 – £50,000
- Higher rate: 40% between £50,001 – £150,000
- Additional rate: 45% above £150,000
If you live in Scotland, you will pay the following rates of Scottish Income Tax on your director’s salary:
- Personal Allowance rate: 0% on annual income up to £12,500
- Starter rate: 19% between £12,501 – £14,549
- Basic rate: 20% between £14,550 – £24,944
- Intermediate rate: 21% between £24,945 – £43,430
- Higher rate: 41% between £43,431 – £150,000
- Top rate: 46% above £150,000
Please note: You will not get a Personal Allowance if your annual income is greater than £150,000.
The Class 1 National Insurance contributions (NICs) that you will pay on a director’s salary are:
- 0% on earnings up to £166/week
- 12% on earnings above £166/week and up to £962/week
- 2% on earnings above £962/week
The company will also pay 13.8% Employers’ National Insurance on your director’s salary income above £169/week (2020/21 threshold).
Shareholder dividends
Dividends are paid to shareholders from company profits after Corporation Tax has been deducted. Unlike salaries, they cannot be counted as a business expense. This means you can only issue dividends if the company has remaining profits after tax.
If there is no surplus income after running costs, salaries and wages, and business taxes have been deducted, you cannot pay yourself dividends.
Given that a company’s profits will fluctuate, you can choose to issue dividends on a fixed schedule like salary payments, or on an ad hoc basis when the company has sufficient surplus cash to justify dividends.
Many company owners choose to reinvest at least some of their trading profits in the business, rather than taking it all as dividend payments. It is also sometimes beneficial to leave surplus cash in the company until a future tax year, for example: to avoid going into a higher Income Tax band.
A common misconception is that dividend income is tax free. This is incorrect. Whilst shareholders do get a £2,000 tax-free dividend allowance, they are legally required to pay dividend tax on annual dividend income above that amount. This must be reported each year on a Self Assessment tax return.
Dividend income above £2,000 is subject to the following dividend tax rates, which are based on your Income Tax band:
- 5% if you are a Basic-rate taxpayer
- 5% if you are a Higher-rate taxpayer
- 1% if you are an Additional-rate taxpayer
To work out how much dividend tax you need to pay, you must calculate your total annual income from all sources, including your director’s salary, dividend payments, and any other taxable income you receive. Depending on how much you earn in a tax year, you may have to pay more than one rate of dividend tax.
Dividend tax does not apply to dividends from shares in an ISA.
Directors’ loans
Directors can also withdraw money out of a company by way of a director’s loan. This applies when you take money from the company that is not:
- your director’s salary
- dividend payments
- reimbursement of expenses
- money that you have already paid into the company
- money that you have loaned to the company
Any money you lend to the company, or borrow from the company as a director’s loan, must be recorded in a director’s loan account. Both you and the company may be required to pay tax on a director’s loan, depending on whether it is overdrawn (you owe money to the company) or in credit (the company owes you money).
