There are a variety of reasons why businesses or consultants may choose to operate via a limited company.
For some, the protection limited liability offers is a key benefit. For others, the potential tax benefits are the main reason why they choose to be a limited company over a sole trader.
To explain more about the tax advantages of a limited company, we asked Manchester-based accountants Alexander & Co to outline the tax-effective ways you can pay yourself if you own a limited company.
1. Paying yourself a salary
Salaries are the most common form of remuneration if you are a business owner. If a company pays salaries it will operate via the PAYE scheme and report to HMRC through the real-time information system (RTI).
For a business owner operating via a limited company, it is worthwhile considering drawing down a small salary as part of your overall remuneration package.
A salary of at least £9,568 (the national insurance primary threshold for the 2021/22 tax year) will mean that you will still be making eligible national insurance contributions towards your state pension.
A salary of up to £12,570 (assuming that there is no other income except dividends) will be covered by your personal allowance and should be free of income tax, although a small amount of national insurance will still be due.
Salaries are a deductible business expense for the company, so will reduce the amount of corporation tax the limited company will need to pay.
Taxation of salaries for the 2021/22 tax year
For the 2021/22 tax year the taxation of salaries is as follows:
- The personal allowance is £12,570. Salaries falling within this amount, assuming no other income, do not incur tax.
- Between £12,570 and £50,270, a tax rate of 20% applies.
- Between £50,270 and £150,000, a tax rate of 40% applies.
- Over £150,000 a tax rate of 45% applies.
In 2021/22 employees are required to pay the following national insurance contributions:
- Class 1 contributions at 12% for salaries ranging between £184 and £967 a week
- 2% on earnings which go above £967 per week
In addition, employers must also pay NI contributions:
- 13.8% class 1 contribution on salaries above £170 per week (£8,840 per year).
Did you know? Employee and employer NICs are never due on dividends but always on salaries.
A tax-efficient company director’s salary should aim to sit between two National Insurance thresholds:
The lower earnings limit
For 2021/2, the limit is £120 (£6,240 per year). As a director, you will want to be earning above this to maintain your entitlement to future benefits and state pensions.
The primary threshold
For 2021/22 the primary threshold is £184 per week (£9,568 per year). The aim is to sit below this. If you earn above this threshold you will have to start paying NICs.
If in some weeks or months you earn over the primary threshold, you will pay Class 1 NICs (even if your annual income overall is less than the primary threshold).
Fluctuation in earnings may mean you may pay NICs within some periods and not in others and so budgeting for this is essential.
The Employment Allowance
The Employment Allowance (EA) allows business owners and charities to remove up to £4,000 from their national insurance bill each year.
First introduced in April 2014, the EA will refund any employers’ NI contributions your company pays during the tax year. However, not all companies are entitled to claim the employment allowance.
Eligibility for the Employment Allowance
A company is not eligible for the Employment Allowance if:
- Only one employee (or director) in the limited company is paid above the Secondary Threshold which, for the 2021/22 tax year, is £170 per week (£8,840 per year).
- You employ someone for personal, household, or domestic work (unless they’re a care or support worker).
- You’re a service company working under the IR35 rules and your only income is from the earnings of the intermediary.
- You’re a public sector firm doing more than 50% of your work in the public sector (unless you’re a charity).
You can learn more about this on the HMRC Employment Allowance page.
2. Paying yourself via dividends
If a limited company has made a profit after paying corporation tax, this can be distributed to the shareholders of the company in the form of dividend payments.
Recipients of dividend payments will need to pay tax on their dividends. Depending on the amount of dividend income, you may be eligible for the tax-free dividend allowance.
For the 2021/2 tax year, the tax-free dividend allowance is £2,000. This means that you won’t have to pay any tax on your first £2,000 of dividend income each tax year.
If you receive over £2,000 in dividend income, the tax implications are as follows:
- The Personal Allowance for the 2021/22 tax year is £12,570. If your total salary and dividend income for the year falls within this amount, no income tax will be due on them.
- By combining your Personal and Dividend Allowance, you can receive up to £14,570 income free of income tax in the 2021/22 tax year.
- If your combined salary and dividend income exceeds £14,570 in the 2021/22 tax year, you will need to pay tax.
Dividend Tax Rates for the 2021/22 tax year
- If you receive dividends of up to a value of £50,270 a tax rate of 7.5% applies after you have used up your Personal Allowance and the £2,000 Dividend Allowance.
- For dividends over £50,270 and under £150,000 a tax rate of 32.5% applies.
- Over £150,000 a dividend tax rate of 38.1% applies.
3. Making contributions to your pension
Limited companies can also make pension contributions on behalf of their employees or directors.
The pension rules are complex and advice should always be sought, but in very broad terms, the contribution (when it is paid by the company) is corporation tax-deductible and, assuming the contribution falls within the person’s available pension allowance, it will not be taxed on the individual until such time as they draw it out of the pension.
Even then the individual, under current rules, has the opportunity to draw out 25% of their pension fund completely free of tax (in most cases).
An individual’s pension annual allowance is usually £40,000 per tax year.
Unused allowances from the previous three tax years can also be used. This can be a very tax-efficient way of extracting funds from a limited company
Tax-efficient business planning
As mentioned at the beginning of this article, a limited company can be tax-efficient if the circumstances are right, but all methods may not be suited to all businesses.
The tax benefit to a company is not the rates of tax at which salary and dividends are charged, but the fact that as a company owner it is possible to control when funds are extracted from the business and control the timing of the tax.
You may also be able to extract these funds to other family members, who may be involved with the company.
In the right circumstances, and with a combination of salary, dividends, and pension contributions, together with distributing wealth around family members, a limited company can help you to achieve a highly tax-efficient business.
Business health warnings
Unfortunately, as with most things in business, tax is not all plain sailing, and there are certain traps you need to be aware of and are best avoided.
The list below covers a few of them but it is by no means comprehensive:
- Directors cannot provide director services from a company. As a result payments for director services will always be subject to PAYE and national insurance.
- A director can provide non-director services from a company, although separate contracts would be required to prove that this is the case.
- If you operate from a company but say, only work for one part of it, then you may be considered an employee by HMRC.
- In these circumstances, your company may be charged PAYE and national insurance on the payments it receives, and the company may also be liable for the employers’ national insurance.
- HMRC may challenge circumstances where they think dividends are being paid instead of a salary. For example, if you grant employees shares where the only rights are to a monthly dividend, HMRC are likely to treat this as salary.
- HMRC may also challenge situations where they see profits being shifted. For example, an 80% shareholder takes a small dividend but pays their spouse, who is a 20% shareholder, a very large dividend to use their allowances.
- There may also be other tax consequences that should be considered. For example, inheritance tax or capital gains tax alongside the consequences of moving shares between family members or other people. With tax efficiency advice from qualified professionals, all of this can be planned for.
Companies can be very tax-efficient vehicles if the circumstances are right. You should work with your tax advisor or accountancy firm to ensure that you have the correct structure in place and make sure this is reviewed regularly to keep up with changing rules and regulations.