If you're operating a limited company as a contractor, it's important to get a good handle on how salaries and dividends work in order to draw income from your business in a tax efficient way. This guide looks to set out the considerations for such, to help you do just that
Umbrella Company Contractors
If your earnings are being processed via PAYE (Pay-As-You-Earn) under an umbrella company, your income will be subject to the usual PAYE deductions for income tax and National Insurance (NI). Umbrella companies tend to offer different perks, and rates for service charges, so 'shopping around' can be beneficial before choosing a provider.
Limited Company Contractors
Operating under your own limited company give you far more flexibility as to how and when to pay yourself. Assuming the work is IR35 compliant, most limited company contractors draw down income in the form of dividends and a small salary. The main benefit of this is that dividends are not subject to National Insurance contributions, whereas a standard salary is. A contractor on £300 a day, with 6 weeks of unpaid leave, can expect to pay around £10,000 less in tax each year than a self-employed umbrella contractor.
Paying yourself a salary
You should look to pay yourself a salary from your limited company as the cost is tax deductible from the corporation tax submission. You'll need to consider how much to pay yourself though; too much and the benefits will diminish if you pass through the tax bands and National Insurance thresholds. Here are some of the main points you should take into consideration:
- For 2015/16 the personal allowance is £10,600. You will not pay any income tax if your salary does not pass this threshold
- You only start paying NI contributions when your salary reaches above £8,060 (2015/16)
- 'Employment Allowance' which was introduced in 2014 to stimulate the economy, allows any company to write off the first £2,000 of it's overall NI bill each year
With the above points in mind, if you pay yourself £10,600 for the current tax year:
- You will pay no income tax at all, and the salary is deductible against the companies corporation tax bill, which will save you about £500
- You will only pay employee NI contributions above £8,060, which works out to £304.80
- Employment Allowance allows you to wipe off up to £2,000 of employer NI contributions which means that you'll have £343.44 refunded for that year for NI contributions made by the limited company
Normally you would pay yourself on a quarterly basis via the company payroll. Since April 2013, details of tax and NI contributions are sent to HMRC via Real Time Information (RTI). It's strongly recommended to use an accountant when operating a limited company, as it's an investment which will end up saving you money. Your accountant should be able to process your quarterly bill bill for you, or at least advise as to how the RTI process works, if you elect to do the regular submissions yourself.
How do dividends work?
Any profits leftover after all tax obligations have been fulfilled, can be redistributed as dividends. This simply means a payout on a pro-rata basis per share, for each shareholder. It's likely that you'll be the sole shareholder in your company, in which case you'll be paying yourself dividends to make up for the small salary you're paying yourself. Many people choose to pay themselves quarterly for convenience, but there are no rules as to how often you can pay yourself dividends.
You may decide to split the ownership of your company with someone else, e.g. your spouse. This may be beneficial in certain situations, as it will allow you to benefit from both of your tax-free personal allowances.
Dividends must be paid to each shareholder in amounts equitable to the percentage of shares held. To do this, the company must make an official record of the dividend declaration, via board meeting minutes. Dividends are then paid to each shareholder via vouchers, which can be paper or electronic. These vouchers are then used by each person when filling in their annual self-assessment tax return.
How are dividends taxed?
You only pay tax on dividends if you're a 'higher' or 'additional' rate taxpayer. If you're filling in your own self-assessment, it's fairly straightforward to list the details on the 'dividend' section of the HMRC form. The tax office will then contact you to tell you what you owe based on the following dividend tax rates:
Dividend Tax Rate
Basic rate and non-taxpayers