The answer to that question is one often asked of accountants and the answer is simple. You just have to work through the options that might influence the decision.
In most cases a director's pay is determined by simple market forces.
The optimum pay question only arises when a director has the choice to vary the mix of salary and dividends they take with a view to minimising the tax they and their company pay. The preserve of the smaller owner/director sector.
In recent years many directors have paid themselves minimal salaries that match the personal tax allowance and taken out the rest of their company's available profits by dividend to avoid paying National Insurance tax.
That major tax advantage was curtailed, but not completely eroded, with the introduction of the new personal dividend tax on 6th April 2016. In future tax payers will now pay extra tax on the dividends received after the first £5,000. The extra tax will be assessed at 7.5% for basic rate tax payers, and 32.5% for higher rate tax payers.
The following table confirms that a director will still save a hefty £4,719 in tax by extracting a fairly typical £50,000 of available profits by dividend as opposed to salary.
The tax saving differential reduces to only £3,127 if the Employers Allowance of £3,000 is added into the mix.
So whilst the new dividend tax may have reduced the tax advantage to be gained by choosing a low salary and voting through higher dividends, it has not completely eroded the benefit of continuing with that option.
So we will stick with the premise that small company directors will still favour taking relatively lower salaries and higher dividends. We just need to look at what factors may affect the level of salary chosen.
On the 1st April 2016 the new mandatory National Living wage came into effect. It requires all employees aged 25 and above to be paid a minimum of £7.20 a hour. This will mean most directors working a standard 35-hour week should be paid a salary of at least £13,104 a year. This is £2,104 higher then the optimal tax saving salary of £11,000 that would otherwise be recommended if the Employers Allowance can be taken advantage of in 2016-17. Unfortunately a change in the last budget removed the option to claim the Employers Allowance in single employee companies from this year.
Although the HMRC have certainly rattled the cage bars in the past, the HMRC rarely seem to challenge directors who pay themselves well below the Minimum National Wage rate.
We suspect the current national debate on the morality of tax payers 'legally' minimising their tax liability is effectively handing a popular mandate to the HMRC to be much more aggressive in applying the Laws that do exist. It would not surprise the author if the HMRC were to have a pop at those directors that continue to claim a salary lower than the NLW when their accounts suggest they are working more hours than the rate would allow. Of course the NLW will be the lever that opens the enquiry, but it would be a very optimistic tax payer who assumes the HMRC's interest in their tax affairs will start and stop there.
The extra tax a full-time director would pay by taking a salary of £13,104 instead of £11,000 is pretty low. So we anticipate many directors will elect to take the higher salary to avoid precipitating an unwanted HMRC tax enquiry for the sake of a few hundred pounds.
The new personal dividend tax has done exactly what it was intended to do. It is now much less attractive to incorporate to take advantage of the tax breaks that previously existed.
Of course most contractors have to incorporate in order to be considered for work. So the tax treatment is very much a secondary consideration.
That said, now is the time for directors of personal service companies that undertake contracts that might fall within the scope of IR35 to change their strategy on profit extraction. It is time to start paying yourself a higher and more commercially realistic salary now that the tax advantage of taking dividends has been significantly reduced.
The author is coming around to the HMRC apparent focus on the question of client 'control' of the contractor to determine IR35 status. Reduced to its simplest form, if the client has day-to-day control so that they can decide what tasks the contractor will works on … then IR35 will probably apply. If the contractor is taken on to fulfill a distinct project and the contractor controls how the work is carried out … then IR35 would most likely not apply.
If the contract is so grey and uncertain, there is now a strong argument for directors to cut the risk they are running of being caught out and settle for a higher salary and lower dividends mix.
The higher salary will serve to mitigate the outcome of an adverse IR35 tax investigation should you be unlucky enough to suffer one, and there is the always the argument that by paying a higher salary you reduce the chances you will be selected for an IR35 investigation in the first place.
If it is likely you will be applying for a mortgage in the next three years, you may wish to maximise your salary at the expense of taking smaller dividends.
You will need to talk to a mortgage adviser who can advise you on what mix of salary to dividends lenders are currently looking for. It does seem to us, however, that lenders are much more likely to lend more at a favourable rate to directors with a history of high salaries topped off with small dividends rather than the reverse.
It is perfectly normal to find a small business where some of the directors work longer hours and contribute far more to the profitability of the company than others. In such circumstances it is only fair that those who work the hardest should be rewarded for the extra contribution they make to the success of the business.
If the directors decide to extract the profits by dividends, everyone tends to agree to the principle of reward for endeavor until it comes to the point where they have to agree how the profits are actually to be shared out. Then the bun fight, sadly, commences.
If you have a company where directors work different hours, then it is often better to agree a unified hourly rate and then pay a salary each month based on the number of hours each director worked. Residual profits can then accumulate and be shared out on an equal basis periodically. This way the level of remuneration attributable to endeavour is taken at a time when everyone can better relate to the work put in by each individual. Delay the point at which all the profits are shared out by dividend alone for any length of time and people start forgetting or will even challenge who did what.
Of course saving tax is not always the best deciding factor for choosing your salary level. If you are looking for some free advice on how to plan your remuneration package, then call Ralph Elliott-King on 01202 482121.
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