Ways to pay income to a company director in the UK

You are a company director and want to draw income from its operations. You're wondering which method is the most tax-efficient. Below, we present descriptions of strategies that will help you decide on the most tax-advantageous way for the company to pay you.

Director's Salary - Pros and Cons

The advantages of a director receiving a salary are as follows:

• building up qualifying years for the state pension;
• you can pay higher contributions into a personal pension;
• you can retain maternity benefits;
• easier to apply for mortgages and insurance policies, e.g., critical illness cover;
• reduction in the amount of corporation tax paid by the company (as salary is an allowable business expense);
• you can draw a salary even if the company is not making a profit.

Unfortunately, there are also a few downsides, the biggest of which is that a director's salary is paid in the same way as for any other company employee, it must therefore be reported according to HM Revenue & Customs rules – in real-time (Real Time Information – RTI) and both the company and the director must pay National Insurance Contributions (NIC – National Insurance Contribution).

How to decide how much salary to pay a director?

You don't pay income tax on earnings until you exceed the personal allowance (the tax-free personal allowance – which is £12,570 for the 2022/23 tax year). However, you will have to pay NIC contributions if your income exceeds the NIC Primary Threshold - £11,908 for the 2022/23 tax year.

Please note that to accrue qualifying years for the state pension, your salary must be equal to or higher than the NIC Lower Earnings Limit (£6,396 for the 2022/23 tax year).

Therefore, some directors set their salary at a level between Lower Earnings Limit and Primary Threshold, to preserve their state pension entitlement but avoid paying NI contributions. 

Dividends

A dividend is a share of a company's profits, meaning what remains after the company has settled all its liabilities, including taxes. If there are no profits, no dividends can be paid.

Dividends can be received by board members and shareholders. The payout is distributed proportionally based on the number of shares held. There is no requirement for all profits to be paid out this way, nor is there a requirement to distribute them at all. Profits can be accumulated and paid out according to arrangements made by the company's management.

From a tax perspective, it is beneficial for a company director to receive most of their income in the form of dividends: they are subject to less income tax than a salary and are not subject to National Insurance contributions.

They can significantly reduce the amount of income tax. The dividend allowance (dividend allowance) for 2022/23 is £2,000.

Below is a comparison table for the 2022/23 tax year:

* _{Please note that tax thresholds in Scotland are set at different levels than in the rest of the UK. You can find them at this link. The dividend tax rate is set uniformly across the entire country.}

Example.

Bartek receives a salary of £11,900 annually, keeping it below the NIC tax threshold and the basic income tax threshold. He receives £30,000 in dividends. His total income is therefore £41,900.

For the 2022/23 tax year, he is entitled to a tax-free allowance of £12,570, leaving a taxable amount of £29,330. The dividend allowance deducts another £2,000 from this amount, resulting in £27,330. This amount is taxed at the basic rate of dividend income tax, which is 8.75%. The tax bill for this year: £2,391.

If Bartek were to receive his entire income of £41,900 as a salary, then after deducting the tax-free allowance, £29,330 would remain (£41,900 – £12,570). From this amount, 20% tax would have to be paid, totalling £5,866.

In addition, the company would have to pay NIC (National Insurance Contributions) on his salary, amounting to £5,552 (13.25% of the salary). Therefore, the total tax bill under this option would be £11,418, which is £9,027 more than with a mixed payment approach.

Despite the above calculations, using dividends also has its drawbacks. They can only be paid from company profits, so your income might not be predictable. Furthermore, they are paid after Corporation Tax has been deducted (an employee's salary is a deductible expense).

A dividend paid out without sufficient profits to cover it becomes a director's loan – and this must be repaid. Finally, dividends do not count towards tax relief on pension contributions made by an employee (this topic is expanded upon below).

From the above, it follows that to derive most of your income from dividends, you need to maintain very accurate accounting records to allow for timely declaration of profits and losses. Therefore, it's best to seek advice from a good accountant on this matter.

Company pension contributions for a director

Such a contribution is treated by the tax authorities as being paid by the employer. It does not increase income, and therefore does not increase the amount of tax payable. It is an allowable business expense, and in this way, we save 19% Corporation Tax in the 2022/23 tax year - Corporation Tax (this tax will be as much as 25% from April 1, 2023).

There is also no need to pay employee National Insurance contributions, which is another 13.8% saved.

A huge advantage of such contributions is that they are not limited by salary amount, unlike contributions made by an individual, who cannot pay more into a pension than their annual earnings (so if you choose the option of a small salary and dividends, as shown above in Bartek's example, you cannot contribute much towards a future pension).

For pension contributions paid by the company, the only limitation is the annual allowance – currently £40,000. As a result, the company can contribute funds towards a pension up to this amount annually, even if the director's salary is small.

Does this strategy have drawbacks? Yes. The main one is that funds can only be accessed after reaching the age of 55, so such contributions will not replace a salary or dividends.

Bonuses for directors

Paying employee bonuses to directors can be very beneficial for a company's tax efficiency, though it's important to make the payments at the right time of year.

A director's bonus, as an expense included in business costs, is deductible from the company's profits, thus reducing Corporation Tax (CT – Corporation Tax). On the other hand, it is treated as employment income, so it is subject to PAYE and National Insurance contributions.

An important piece of information is that these contributions are payable from the date the bonus is approved, even if it is actually paid at a later date.

However, this payment must be made within nine months of the end of the accounting period in which it was awarded. This deadline must be strictly adhered to, because if it is exceeded, it will delay the deduction, which will then apply to the accounting period in which the payment was made, rather than the previous one.

The best time to award a bonus is a short period before the end of the company's accounting period, because for a tax deduction to be claimed in relation to the bonus, there must be an obligation to pay it. Therefore, if the decision to award the bonus exists on the last day of the accounting period, i.e., it was made before its end, the terms and method of bonus payment can be determined later.

For income tax purposes, a bonus is treated as paid on the day the director becomes entitled to it, even if the actual payment date is later. It is the date the entitlement to the bonus arises that triggers the obligation to pay PAYE and NI taxes.

However, it is important to remember that directors' bonuses cannot simply be deferred by imposing restrictions on the right to withdraw these amounts – precisely because they are treated as paid when recorded in the company's books and records, e.g., in a director's credit account, and not at the moment of physical payment from the company's bank account.

What are the advantages of such a bonus arrangement? Since the bonus does not have to be paid within nine months of the end of the accounting period, the decision on its amount can be made later. This allows for an estimation of the company's profit before it is reduced by the payment of the director's bonus.

Example.

Bert LTD's accounting period ends on March 7, 2023. On March 4, at a board meeting, the company's directors award themselves a bonus of 15% of the company's profits, the amount of which they know from the financial statement just prepared. This statement includes the expense generated by the decision to pay the bonus.

If bonuses are paid by December 7, 2022 (inclusive), then corporation tax relief can be applied. The date on which the PAYE liability arises is the date the bonus amount is determined.

Since the finalisation of Bert Ltd's financial statement will take place in May 2023, the directors will be taxed on the bonus in the next tax year – 2023/24, even though the year in which the bonus was approved was the accounting year 2022/23.

Important! If the bonus is included in the financial statement but not paid before April 6, 2023, it is important to remember that a higher rate of social security contributions (15.05%) will then apply. Granting a bonus that qualifies for Corporation Tax (CT) deduction is only possible after this date.

The moment the decision to pay a bonus is made does not trigger the payment for PAYE purposes – it is the moment the bonus amount is determined, or the date on which the bonus becomes available for directors to use, if this occurred earlier than the formal date of its determination.