In Part 1 we established that dividends are the most tax efficient way to receive an income from business activities.
Sticking with the perspective of a basic rate payer:
All UK tax payers receive a personal allowance on which they pay 0% income tax (wherever it comes from) on the first £9,440 (all rates and thresholds are correct as of tax year 2013/14) of income received. The threshold is a bit lower for national insurance contributions at £7,748.
Paying yourself a salary reduces your company profits and therefore reduces your corporation tax liability. So if you pay yourself a salary up to the 0% national insurance threshold you are reducing your corporation tax whilst not creating any additional tax for yourself. Win win!
That is why most small business owners pay themselves about £7,680 a year as salary and the remainder in dividends. Creating an additional tax saving of £1,536 a year (20% of £7,680). There is a bit of admin involved in this, you will have to register for PAYE and meet all the HMRC requirements that PAYE involves, but if you get an accountant they will do all that for you. It’s part of our standard service for our Contractor and Small Business clients.
Move on to section 3 of our Dividend Guide to understand the dividend tax credit (the bit that means basic rate tax payers pay 0% income tax on dividends).