Where a business is run as a family or personal company, the company is separate from the shareholders and those who run it. This means that where funds are required outside the company to meet personal bills and suchlike, they have to be extracted from the company.
There are tax implications for both the company and the individual recipients. Not all extraction routes are equal, and the tax and National Insurance contributions (NICs) consequences depend on the route taken.
A popular strategy: Small salary plus dividends
A popular profit extraction strategy is to take a small salary and extract further profits as dividends.
This strategy can be tax-efficient, but it depends on the personal allowance being available and the company having sufficient retained profits from which to pay the desired dividend. The salary level is key to ensuring this approach remains tax-efficient. However, the optimal salary level will depend on particular circumstances and whether the employment allowance is available.
Why pay a salary?
Aside from the tax benefits that can be secured by paying a salary at the optimal level, paying a salary at least equal to the lower earnings limit for NICs purposes will ensure that the year is a qualifying year for state pension and contributory benefit purposes.
To receive a full single-tier state pension, a person needs 35 qualifying years. A reduced state pension is paid as long a person has at least ten qualifying years but does not have the full 35 years; the pension payable will reflect the number of qualifying years.
Where a director or shareholder does not have the full 35 qualifying years, paying a salary at least equal to the lower earnings limit will boost their state pension requirement. As contributions are payable at a notional zero rate on earnings between the lower earnings limit and the primary threshold, where the salary falls within this band a qualifying year can be secured for zero contribution cost.
Tax benefits and optimal salary level
Salary payments and any associated employer’s NICs are deductible when computing the taxable profits of the family or personal company and will save tax at the rate of corporation tax paid by the company. For the financial year 2021 (starting on 1 April 2021), as for the previous year, this saving is at the rate of 19%.
On the other side of the equation, a salary paid to a director or family member may, depending on the level of that salary and the extent to which the recipient’s personal allowance remains available, attract income tax, employee’s NICs and employers’ NICs.
It will be worth paying a salary up to the level where the associated corporation tax deduction outweighs the tax and NICs payable on that salary. The point at which this is reached will depend on whether the employment allowance is available (or whether the director is under the age of 21). The optimal salary level will also depend on whether the recipient’s personal allowance remains available in full to set against any salary that is paid.
The employment allowance is an allowance that eligible employers can set against their employers’ (secondary) Class 1 NICs liability. The allowance is £4,000 for 2021/22 but is capped at the level of the employer’s secondary Class 1 NICs liability for the year.
Not all employers are eligible for the employment allowance; companies where the sole employee is also a director do not qualify, which means personal service companies with one employee who is also a director do not benefit from the allowance.
The availability or otherwise of the allowance impacts the optimal salary level for 2021/22.
Optimal salary: Employment allowance not available
If the employment allowance is not available, as is likely to be the case in a personal company scenario, employers’ secondary NICs will be payable on earnings above the secondary threshold, set at £170 per week, £737 per month or £8, 840 per year for 2021/22 (unless the director is under the age of 21).
However, as the primary threshold is set at a higher level than the secondary threshold, no employee contributions are payable until earnings exceed £184 per week, £797 per month or £9,568 per year. When dealing with directors, remember that directors have an annual earnings period, and the relevant thresholds are the annual thresholds.
Assuming the full personal allowance (£12,570 for 2021/22) is available and has not been used elsewhere, no income tax is payable until the salary exceeds this level.
While paying a salary equal to the secondary threshold of £8,840 will mean that the salary can be paid free of tax and both employers’ and employee’s NICs, this is not the optimal level. Salary payments and the associated employers’ NICs are deductible for corporation tax.
Where a salary exceeds the secondary threshold up to the level of the personal allowance, employers’ NICs is payable at 13.8%. However, this is outweighed by the available corporation tax relief of 19%.
Once the salary exceeds the primary threshold of £9,568, employee’s NICs of 12% is also payable. However, while the salary remains below the level of the personal allowance, there is no tax to pay.
Once both employers’ and employee’s NICs are payable, the combined cost exceeds the available corporation tax relief. Consequently, the optimal salary for 2021/22, where the employment allowance is not available, is equal to the primary threshold of £9,568.
However, at this level the employer will have to pay employers’ NICs of £100.46 to HMRC. The administrative burden of this can be minimised where the director is paid monthly, by ensuring that an annual earnings period is used for the director throughout the year, rather than using the alternative arrangements. Adopting this approach will mean that the employers’ NICs can be paid in full in the final month of the year, avoiding the need to make small payments on account of the secondary NICs liability each time the director is paid.
Employment allowance available
Where the employment allowance is available (e.g. in a family company scenario where there is more than one employee), as long as the allowance has not been utilised elsewhere, there will be no NICs to pay until earnings reach the primary threshold of £9,568. Above this level, primary contributions of 12% are payable. However, the cost is outweighed by the corporation tax relief on the salary. No tax is payable until the salary reaches £12,570.
If a salary exceeds the personal allowance of £12,570, the director will suffer both employee’s NICs at 12% and income tax at 20%. The combined cost will outweigh the corporation tax relief on the salary.
Consequently, the optimal salary is one equal to the personal allowance, set at £12,570 for 2021/22. Again, ensuring an annual earnings period is used from the outset for the director will minimise the associated administrative burden. Remember, also, to claim the employment allowance.
Director under the age of 21
Employers’ NICs are not payable on the earnings of a director under the age of 21 until they exceed the upper secondary threshold, set at £967 per week, £4,189 per month and £50,270 per year for 2021/22.
The optimal salary for a director under the age of 21 is one equal to the personal allowance of £12,570. Primary contributions will be payable by the director on earnings in excess of the primary threshold of £9,568 at the rate of 12%. However, no secondary contributions will be due.
Take account of personal circumstances
As personal circumstances vary, there is no ‘one size fits all’ solution.
For example, if the director is eligible for the marriage allowance and the employment allowance is available (or the director is under the age of 21), the optimal salary will be equal to the director’s higher personal allowance (i.e. £13,830 for 2021/22). For personal and family companies looking to extract profits in the form of a tax-efficient salary plus dividends, the optimal salary will depend on the recipient’s personal circumstances and whether the employment allowance is available. There is no substitute for ‘crunching the numbers’.