Contractors' Questions: Should I pay low or no salary alongside dividends?

Contractor’s Question: I currently use the low salary and high dividend arrangement to pay myself through my own limited company. Although this serves to keep my tax liability low, I spoke to one limited company owner who claims he pays almost no tax due to taking only dividends; with no salary whatsoever. He admitted not paying himself a salary may cause difficulty if he tries to get a mortgage, but he didn’t speak of any other adverse implications, in terms of tax or compliance.

Am I missing a trick in terms of the most tax-efficient way to pay myself as a limited company, or is he missing a regulation or two? In other words, can I just take everything out as dividends and avoid salary altogether for an even smaller tax bill, or is that not lawful? I didn’t tell the limited company owner, but surely the tax authority would perceive what’s he’s doing as tax avoidance. Hector certainly would be interested if he could hear how this consultant spoke about his motivations for not paying a salary!

Expert’s Answer: It is entirely at the discretion of the director (or directors) of a limited company to determine how they remunerate themselves. This can either be by way of dividend; directors fee (salary) or a mix of the two. It is therefore possible to pay yourself entirely by way of dividend if you wish, providing you are also a shareholder of the company.  

It is more common for there to be a mix of the two, however, so usually a relatively low salary with the balance of any company profits being paid to the director as a dividend. The reason this approach is favoured is that a salary is an allowable expense for the company, whereas a dividend is not. The person you spoke to may not therefore be paying any income tax on their dividends. However their company will be paying 20% corporation tax on its profits used to pay the dividend.  
 
It is therefore more tax-efficient for a limited company director/shareholder to pay or receive a salary close to their personal allowance (£7,475 for the current tax year, increasing to £8,105 from 6 April 2012). This ensures the company receives corporation tax relief at 20% on the salary and the director does not have to pay any income tax or national insurance. The balance of any company profits after corporation tax can then be paid as a dividend.
 
It is also worth considering entitlement to state benefits. If you receive a salary over the lower earnings limit (“LEL”) for National Insurance (currently £5,304 per year) you are generating NI credits for certain state benefits such as the contribution-based Jobseeker’s Allowance, Incapacity Benefit, State Retirement Pension and Maternity Allowance.

Taking a director’s fee up to the LEL, means that you don’t have any National Insurance or tax deducted from it. This is because the limit at which you have to pay National Insurance and tax is slightly higher. Dividends do not contribute to these benefits which is why, aside from the tax position, it would be advisable to pay a mix of a small director’s fee and dividends.

The expert was Matthew Fryer, tax expert at contractor accountancy firm Brookson.