Most people decide to take a tax-efficient strategy of taking a small salary and extract further profits from their business as dividends. So, the starting point of the strategy is deciding on the most optimal salary.
When the director does not have the requisite 35 qualifying years to provide access to the full single tier state pension paying a salary at least equal to the lower earnings limit for Class 1 National Insurance purposes (£120 per week; £520 per month and £6,240 per year) will make sure that the year is qualified.
What is the maximum salary that can be paid free of tax and National Insurance?
Firstly, it is a matter of what the maximum salary that can be paid, free of income tax and employer’s and employee’s National Insurance. This tax year (2020/21), the thresholds are:
- The personal allowance set at £12,500
- The primary threshold set at £9,500 per year
- The secondary threshold set at £8,788 per year
If the personal allowance has not been used elsewhere, the maximum salary that can be paid without National Insurance or tax liabilities is equal to the secondary threshold of £8,788.
Although, if the director Is under 21, then there is no secondary class 1 liabilities until earnings are over £50,000. In this instance, the maximum salary that can be paid free of tax and national insurance is £9,500 per year (primary threshold).
Is a higher salary tax-efficient?
Salary payments and employer Class 1 National Insurance contributions are deductible for corporation tax purposes and there is a subsequent 19% reduction in the corporation tax bill. When a higher salary triggers a National Insurance liability, then this will be worth paying if it is more offset by the corporation tax reduction.
What about when the employment allowance is unavailable?
In a personal company scenario, it is unlikely that employment allowance will be applicable. Companies where the sole employee is also a director, likewise with a personal company do not qualify.
In this instance, when a director is over 21, a salary more than £8,744 will be subject to a Class 1 National Insurance liability, which is triggered when the salary reaches the higher primary threshold of £9,500 for 2020/21. Employer’s National Insurance at a rate of 13.8% is less than the corporation tax rate, meaning a saving on the salary on employers National Insurance of £163 (19% (£756 x 1.138)), therefore it is tax efficient to pay a salary of £9,500. However, employer’s NIC will need to be paid to HMRC meaning that administration costs will be incurred.
However, beyond these amounts, the combined impact of employer’s and employee’s NI outweighs corporation tax savings. As such, the optimal salary is £9,500.
What about when the employment allowance is available?
When there is a family company, the employment allowance may still be available, meaning a salary of £9,500 free of tax and National Insurance is payable. Following this, if an additional £3,000 is paid, bringing the salary up to the level of the personal allowance will bring forth the employee Class 1 liability of £360 (12% of £3,000). Although, this addition to the salary will reduce the corporation tax bill by £570 (19% of £3,000), making the salary addition beneficial. However, once income tax at 20% is considered, this is no longer the case, meaning that the optimal salary is equal to the personal allowance of £12,500. It’s then best
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