A limited company is a separate entity in law, and all income earned belongs to the company rather than its directors. There are certain ways in which you can extract money as a company director, one of which is taking a salary under the Pay As You Earn Scheme (PAYE).
A combination of this and drawing dividends when the company has distributable profits available, is usually the most tax-efficient way to pay yourself. The best ratio of salary to dividends usually depends on your personal tax situation, and that of your company.
Becoming a company employee
It is not a well-known fact, but directors can be employees of their own company as well as holding office as director. For the purposes of clarity, you should have a written contract of employment that lays out your roles, responsibilities and duties as an employee, as well as the level of remuneration you can expect to earn as a director.
You can take a salary in the same way as other employees, and benefit from the statutory entitlements enjoyed by members of staff. This can be particularly important should the company experience financial decline, as you may be able to claim redundancy payments and other entitlements.
Money withdrawn by way of salary through PAYE attracts tax and National Insurance, as well as the usual employer costs that are borne by the company.
Combine a small salary with dividend payments
As long as you are a shareholder as well as a director, you can also pay yourself by taking dividends, but a combination of these two methods is generally considered the most tax-effective.
Many directors take a small salary plus dividend payments periodically throughout the year, according to the profit levels of the company. The most tax-efficient ratio between the two methods of payment will depend on various aspects specific to your circumstances, including your personal tax allowance.
Other factors include the rate of corporation tax your company pays, which is currently 20% on profit before dividends.
It is important to remember that dividends can only be paid if they are supported by sufficient distributable profit (after tax). This means if you take a dividend and the company cannot afford it, the dividend will be regarded as unlawful should the company enter insolvency.
You will be held personally liable for the money, and potentially open to accusations of misconduct as a director. So before a dividend payment is sanctioned, it is important to first verify your company’s financial position.
One of the reasons why dividends are more tax-efficient is that you do not have to pay National Insurance, as with a ‘regular’ salary under PAYE. Furthermore, you have a tax-free annual dividend allowance of £5,000.
The danger of an overdrawn director’s loan account
If you are used to paying yourself as a sole trader, you will already know that a salary extracted by way of ‘drawings’ is taxed within the self-assessment system. Some directors new to office, or who have previously operated as a sole trader, assume that this is the correct system to use within a limited company.
The problem is that you are liable for considerably more tax if you pay yourself in this way. In the books of a limited company, all money withdrawn that is not a director’s salary, dividend, or a benefit, is recorded in the directors’ loan account and on the company’s balance sheet.
The risk of holding an overdrawn director’s loan account again lies in the potential for insolvency, in which case you will have to repay the money to the company. It would be wise to discuss your remuneration as a director with an accountant, who will be able to calculate the most tax-efficient combination of salary and dividends.
Handpicked Accountants can help in this respect. We can put you in touch with a qualified accountant who will explain all aspects of the process, and provide professional advice on the best way forward. Call today to find an experienced accountant near you.