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Contractor guide to the Employment Allowance

Limited company contractors paying themselves a salary and dividend with no other income such as bank interest or rent could be £164 a year better off if they take advantage of the government’s Employment Allowance scheme.

“Contractors gain a £2,000 contribution towards employer’s National Insurance Contributions (NICs) under the scheme,” explains James Abbott, owner and head of tax at contractor accountant Abbott Moore.

“This means contractors can potentially pay themselves a higher salary, up to the full £10,000 personal allowance.”

How does it work?

Abbott continues: “The idea is that the government wants to reduce the cost for employers to employ someone. In principle, every employer will be given a contribution of £2,000 against their employer’s NIC liability. If their employer’s NIC liability is less than £2,000, they can only claim that element back.

“It applies to all employers with a few limited exceptions, such as nannies and GPs. The vast majority of limited company contractors running their own business will qualify for the Employment Allowance.”

There is also a time limit, so if a contractor is planning to use the allowance, they should ensure they keep on top of it, as they can only claim the allowance for the previous four years.

Contractors making deemed payments are exempt

But Abbott warns that contractors inside IR35 and applying a deemed salary calculation are one of the exceptions not allowed to use the scheme: “Contractors inside IR35 might want to consider whether it is worth them just paying a significant salary, as they may be better off claiming the allowance compared to their 5% expenses allowance allowed under the deemed payment rules.”

Another exception Abbott flags is if a contractor has two or more companies under common control. If one company owns another, or is controlled by the same person, then both won’t receive the allowance and the contractor would have to select just one to benefit.

In principle, every employer will be given a contribution of £2,000 against their employer's NIC liability

James Abbott, Abbott Moore

“Once they have decided to claim, the process is quite straightforward,” says Abbott. “When filing an RTI submission via HMRC’s online portal, a contractor simply has to check a tick-box saying they want to claim. Most payroll software will have a similar function.”

Is it worth claiming the Employment Allowance?

According to Abbott, a common and tax efficient strategy is for limited company contractors to pay themselves a salary that is just below the lower earnings limit, above which point employee’s NICs at 12% will kick in.

“Because the lower earnings limit has not risen at the same level as the personal allowance for income tax, on a salary greater than £7,956 per year employee’s NICs at 12% and employer’s NICs at 13.8% will be due. Of course, a limited company contractor pays both of these amounts from their gross income, so the total tax hit is 25.8% NICs.”

But paying additional salary reduces profits and the corporation tax liability. For example, £1000 left in the company has £200 corporation tax applied, leaving £800 for dividend distribution. Whereas £1000 paid out as salary has no further taxes to pay.

“The Employment Allowance effectively removes the 13.8% employer’s NIC charge, so the contractor pays only 12% on earnings between the lower earnings limit of £7,956 and the personal allowance of £10,000,” highlights Abbott. “The contractor makes a 20% corporation tax saving on the additional salary, which nets out at £164 per year.”

A pitfall – other income

This calculation only works in the contractor’s favour if they have no other taxable income, such as bank interest, rental income from a buy-to-let property, or pension payments. A significant alternative income could leave the contractor out of pocket if they then attempt to use the scheme.

Abbott provides an example where a contractor has rental income of £6,000 a year from a buy-to-let property:

Example 1 Example 2 Example 3
Company Profits 20,000 20,000 20,000
Salary -4,000 -7,956 -10,000
P CT 16,000 12,044 10,000
CT -3,200 -2,409 -2,000
Dividend 12,800 9,635 8,000
Contractor Salary 4,000 7,956 10,000
Rental income 6,000 6,000 6,000
Tax 0 -791 -1,200
NI Fees 0 0 -245
Dividend 12,800 9,635 8,000
22,800 22,800 22,555

In example 1:

  • The contractor has generated £20,000 of profit and takes a salary of £4,000
  • This gives a profit of £16,000 subject to 20% corporation tax, which is £3,200
  • The resulting dividend is £12,800, plus the salary of £4,000 and rental income of £6,000 gives the contractor £22,800 in total
  • There is no income tax or NICs to pay, because the contractor’s salary plus rental income is below the personal allowance and lower earnings limit, and their total income is below the higher rate tax threshold
  • Note that rental income does not attract NICs, and dividends don’t attract income tax until the higher rate tax band is reached.

In example 2:

  • The contractor has generated £20,000 of profit and takes a salary up to the lower earnings limit of £7,956
  • This gives a lower profit of £12,044 subject to 20% corporation tax, which is a lower £2,409 when compared to example 1
  • The resulting dividend is £9,635, plus the salary of £7,956 and rental income of £6,000 gives the contractor £22,800 in total, the same as in example 1, but the contractor is paying £791 in income tax because the salary and rental income combined are greater than the personal allowance.

In example 3:

  • The contractor has generated £20,000 of profit and takes a salary up to the personal allowance of £10,000
  • This gives a profit of £10,000 subject to 20% corporation tax, which is £2,000
  • The resulting dividend is £8,000, but the contractor’s total earnings from the salary at £10,000 plus rental income of £6,000 and a dividend of £8,000 falls to £22,555 as a result of £245 of employee’s NICs and £1,200 of income tax (20% of £6,000, which is the amount the contractor is earning over the personal allowance of £10,000).

“From the 2014/15 tax year, contractors seeking to take advantage of the allowance and who have no other income can pay themselves a monthly salary of up to £830,” suggests Abbott. “Those with other income and who do not wish to use the scheme can pay a salary of up to £660.” Both of these monthly salaries have been rounded down slightly.

When income splitting beware steep salary rises

A final pitfall for married contractors is giving their spouse a salary increase from £660 to £830 a month, which may seem attractive as it would add another £164 benefit, totalling £328.

Abbott explains: “Contractors have to think carefully about the commercial reasoning behind awarding a spouse a salary increase. Does the increased figure reflect the market value of the services the spouse is providing to the company, and could it be justified?

“HMRC would not be impressed with a contractor just giving a spouse a £2,329 pay rise to take advantage of a new scheme, and would most likely challenge such a move, particularly if the spouse is of the ‘stay at home’ variety.”

Abbott concludes: “For such a marginal benefit, many contractors may conclude that it is not worth using the allowance. For those with alternative sources of income, it will almost certainly leave them worse off, so contractors should talk to their accountant before taking any decisions.”

Published: Wednesday, 9 April 2014

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