A Fine Balance between Salary and Dividends
The tax code changes that have been announced by the UK government will have an impact on the way a company owner pays himself. One of the main changes is the increase of the corporation tax rate, which is the tax paid on company profits. The corporation tax rate will rise from 19% to a maximum of 25% from April 2023 for companies whose profits are above £50k. That means that company owners who pay themselves dividends will have less profits left in their company after having paid corporation tax.
Another change is the reduction of the dividend allowance, which is the amount of dividend income that is tax-free. The dividend allowance will be cut from £2,000 to £1,000 from 6 April 2023 and then again to £500 from 6 April 2024. This means that company owners who pay themselves dividends above these thresholds will pay, again, more tax on their dividend income.
If you add to that the fact that in contrast to salary, dividend rate increase was not overturned last year resulting in 1.25 percentage point across the board (8.75% for the basic rate, 33.75% for the higher rate and 39.35% for the additional rate) it's easy to understand why the tax situation has seriously worsen for the UK company owner.
How Tax Code Changes Impact Company Owners
One may wonder if these changes will affect the optimal split between salary and dividends for company owners who want to minimise their tax liability. Paying a low salary and high dividends has been a tax-efficient strategy for company owners, as dividends are not subject to National Insurance contributions and have lower tax rates than salary. However, with the increase of the corporation tax rate, the reduction of the dividend allowance and the increase of the dividend tax rates, this strategy may become less attractive.
One thing is certain, the situation is now a lot more complex. In order to assess the optimum split between salary and dividends, one now needs to know the profit level of the company since it affects its corporation tax rate, the size of the payroll since it affects the availability of the employers allowance (the £5K NIC allowance), the overall level income of the company owner since it affects the availability of the personal allowance and many other factors. While in most situations it's still more tax efficient to take a salary of up to the personal allowance of £12,570 there are many cases where it's not necessarily true anymore.
Because we now have effectively 3 different marginal corporation tax rates, let's look at the effective rates of taxation combining corporation tax, national insurance, and income tax in each different case. We assume that the dividend allowance has already been used.
Corporation tax rate is 19% (profit below £50k)
This situation is identical to that of last year. Depending on which band the taxpayer sits in, these are the effective rates when extracting profit either as a bonus (salary) or as a dividend:
| Personal Tax Rate | Bonus | Dividend |
|---|---|---|
| Basic rate | 40.25% | 26.09% |
| Higher rate | 49.03% | 46.34% |
| Additional rate | 53.43% | 50.88% |
Using dividends is a better option across the board (even though the gap between the two options has significantly decreased over the years).
Corporation tax rate is 25% (profit is above £250k)
In this case here is the comparison:
| Personal Tax Rate | Bonus | Dividend |
|---|---|---|
| Basic rate | 40.25% | 31.56% |
| Higher rate | 49.03% | 50.31% |
| Additional rate | 53.43% | 54.52% |
We can see that now the tax advantage of using dividends has evaporated for higher rate taxpayers. Not by a huge margin but enough to make you wonder why you incorporated in the first place. Obviously, tax is not the only reason you would want to incorporate (see 10 Reasons why it's still worth going Limited for a list of reasons) but still...
Corporation tax rate is 26.5%
Now if your company profit falls between £50k and £250k, the marginal tax rate for profits above the £50k threshold is 26.5%. The reason for that being that companies where the profit is above £250k have a tax rate of 25% on all their profits, not just the highest band. This behaviour is quite different from the one with income tax (if we ignore the whopping 64% marginal band between £100k and £125k). It means that to catch up you need a marginal rate above 25% between £50k and £250k. Here is the split in that case:
| Personal Tax Rate | Bonus | Dividend |
|---|---|---|
| Basic rate | 40.25% | 32.93% |
| Higher rate | 49.03% | 51.31% |
| Additional rate | 53.43% | 55.43% |
As expected, dividends are even less tax efficient than when you are in the 25% bracket.
Conclusion
The recent changes to the tax code have made it increasingly important for company owners to carefully consider the balance between salary and dividends when deciding how to pay themselves. While it's essential to consider individual circumstances and seek professional advice, it's clear that the reduction in the dividend allowance and the rise in the corporate tax rate have shifted the financial landscape for company owners, potentially making it more advantageous to pay a higher salary and rely less on dividends.
