Contractors working through their own limited companies can maximise their post-tax earnings by paying themselves a low salary and the balance in dividends from their company profits.
Despite dividend tax hikes implemented in April 2016, extracting cash from a company via a dividend payment still offers a more tax-efficient alternative to paying oneself a salary. This is in part down to the fact that dividends aren’t subject to National Insurance Contributions (NICs).
Contractors whose spouses are shareholders in their limited companies can also make full use of their spouse’s tax allowance. They can do this by splitting the basic salary and also splitting the dividend income of their limited companies to further reduce their combined tax liabilities and maximise net income.
How your accountant can help with dividends
Before we explain in detail how dividends and taxes are calculated, let us warn you that whilst the calculations are fairly complicated, you should never have to get involved in doing them. Your chosen accountant will be able to advise you, and the cloud based accounting software you use will do this for you. As a rule of thumb, put aside 25% of any dividends paid to you, ready to pay the tax man when you do your annual self-assessment tax return.
Getting the balance right between salary and dividends is crucial for contractors, as it is how most operate. Therefore you should choose an accounting firm who specialises in the contracting industry and understands how to achieve this - see our 10 tips for choosing an accountant. One of the steps for getting your company set up, which your accountant can help you with, will be to put your accounts online using one of the popular cloud based systems like FreeAgent or Xero.
If you are just starting out and haven't yet chosen your accountant them please consider our chosen accounting partner who we recommend for providing specialist accounting services for contractors and small business.
How are contractor salaries taxed?
If a contractor pays a salary above their personal tax allowance (in 2016/17 the allowance is £11,000), the portion above the personal allowance is "taxable income" and income tax rates will apply to that taxable income. Note that the personal allowance published in the Budget is a starting figure. Some people will have tax profiles that mean their tax code (which indicates their tax allowance amount) will vary. Not everyone has a tax code of 1100L and therefore a tax allowance of £11,000. For the sake of trying to keep things relatively simple in these explanations we will however explain the case where someone has a tax allowance of £11,000.
Reminder: Taxable income is the amount of earnings that are subject to taxes. It is the total amount of earnings minus the personal tax allowance for the individual.
The first £32,000 of taxable income is subject to income tax at the basic rate of 20%. After £32,000 is reached, the taxable income is subject to a higher rate of tax at 40% until £150,000. Any taxable income exceeding £150,000 is taxed at the 45% additional rate (based on tax rates for 2016/17).
When it comes to taxing salaries, employees (which applies to a contractors because they are employees of their own companies and take a salary) also pay 12% of gross earnings in employees National Insurance Contributions (NICs) on all earnings over £155 per week, up to £827 per week, after which NICs drop to 2%. This is why most contractors keep their salary portion low, to avoid these taxes.
A contractor’s limited company must also make additional employer’s NICs of 13.8% on the portion of a contractor’s earnings taken as salary which is over £156 per week. This amount is paid by the contractor’s employer – their contractor limited company. So, by keeping the salary low both employers and employees national insurance contributions (NICs) are minimised. This is key to why paying a low salary and the rest in dividends is the most tax efficient route.
But, there is another stealth tax to be aware of. A contractors personal allowance shrinks once their annual income (including all salaries and dividends) exceeds £100,000. For every £2 a contractor earns over £100,000, their personal allowance goes down by £1. For example, someone with a personal allowance of £11,000 will have all of this removed if they earn £122,000 or more because their personal allowance will reduce to zero. For each £2 that is earned between £100,000 and £122,000 it is taxed at 40%, but then an extra pound is now also taxed at 40% because the personal allowance has reduced by a pound - i.e. taxable income has gone up by a pound. This works out at there being an effective marginal tax rate of 60%.
How are dividends taxed?
Dividends are how companies distribute profits to shareholders. As long as the company is in profit, it can declare a dividend at any time. Dividends declared when the company is not in profit are called illegal dividends, and issues arise.
A limited company calculates its profit by deducting its business expenses, such as salaries and other costs such as insurance and accountancy bills, from fee income. Corporation tax of 20% is then deducted from profits and the balance can be distributed as a dividend to the company’s shareholders, typically the contractor and potentially the contractor’s spouse.
Contractors, and other taxpayers, also have a £5,000 tax-free Dividend Allowance. Whilst it is called an allowance it isn't actually one in the usual tax sense. It is actually a "zero rate band", and it eats into the usual income tax bands. The band thresholds (£0, £32,000, £150,000) are used for dividend taxes as for income taxes.
For example, let's say the personal allowance has been used up by taking a gross salary of £11,000. And let's say the rest of their income is dividends. The next tax band to consider is the basic rate tax band from £0 to £32,000 (at the time of writing). Dividends falling within this band are taxed at 7.5%. But the first £5,000 within that band are not taxed at all, due to the Dividend Tax Allowance of £5,000 - so only £27,000 of the £32,000 is actually taxed at 7.5%. Any dividends income falling in the higher rate band (currently from £32,001 to £150,000) attracts the 32.5% higher rate of tax. Then any dividends in excess of £150,000 are subject to a rate of 38.1%. Crucially, dividends do not attract employer NICs.
Comparing salary versus taking a dividend
Contractors taking a minimum salary circa £8,000 and the balance in dividends will end up paying significantly less combined tax and NICs than contractors paying themselves just a salary. This is because the National Insurance Contributions are minimised.
In the limited company scenario, after paying corporation tax at a rate of 20% on the company’s gross profits, a contractor extracting dividends would only have to pay an extra 7.5% tax on the first £27,000 of dividend earnings within basic rate threshold – taking the Dividend Allowance into account. This works out at £2,025. From here it becomes clear that taking the low salary and dividends route is advantageous for maximising net income and minimising tax liabilities.
How you can use personal allowances and split dividends
Contractors who choose to share ownership of their limited company with a spouse or civil partner can benefit from that spouse’s unused tax allowances, assuming the spouse has no other income, by ‘income splitting’.
A contractor could allocate 50% of the shares to their spouse, and retain 50% for themselves. Because dividends are paid according to shareholdings, the contractor would receive 50% of the dividend and the spouse would receive the remaining 50%.
Because the spouse’s personal allowance and Dividend Allowance can be used, there is effectively double the amount of tax allowances available. After corporation tax, a contractor and spouse could collectively take £10,000 in Dividend Allowances from a contractor limited company on top of their personal allowances without paying any more in tax or NICs, by choosing the low salary and dividend option. From here on, they could extract another £27,000 each whilst only attracting the 7.5% basic rate.
Salary vs Dividends – a sample calculation
For this example, we compare the income after taxes for three contractors, all of whom have earned £80,000 in gross contracting fee income. One is paying themselves via a salary, one has taken an £8,060 salary and is taking the rest in dividends, and one is splitting the income via salary and dividends between two equal shareholders.
||Limited Company one shareholder
||Limited company two shareholders
|Gross profit before tax
|Tax on dividends (income tax)
|Income after taxes
What is the settlements legislation (Section 660) and IR35?
The practice of sharing company ownership and the resulting dividends between spouses and civil partners, sometimes called ‘income splitting’, has at times become controversial. HMRC tried to tackle it by resurrecting the settlements legislation, which treats the income earned by the contractor’s spouse as if it were the contractor’s, and tax it accordingly.
However, the taxman’s plans were thwarted when it lost the Arctic Systems test case. After losing the case, HMRC proposed some draft legislation for income splitting, but it never progressed beyond the draft.
Contractors have also been targeted by IR35, introduced in 2000 to tackle disguised employment. If a contractor is found to be inside IR35, they cannot use the minimum salary and dividend option for the period of the relevant contracts, and must instead pay themselves everything via a salary. To find out if you are caught by IR35 you can use our free online IR35 Test.