Small Business Taxation in the UK: Understanding the Basics

Running your own limited company provides greater flexibility over your income Tax, specifically on how and when you pay yourself. This enables you to structure your remuneration more tax-efficiently by taking a director’s salary through PAYE and drawing shareholder dividends at regular intervals or periodically when company profits allow.

Furthermore, directors’ loans and various employee expenses are available, which can go towards an overall ‘package’ of benefits.

To help you establish the most tax-efficient remuneration structure, we will explain the options available to you and discuss the various taxes you must pay.

Employers must deduct Income Tax and National Insurance contributions (NIC) from the salaries of salaried directors through payroll, and pay additional employer’s NIC directly to HMRC, as part of the PAYE system.

Wages are a deductible business expense, so your company will not pay Corporation Tax on your director’s salary. Corporation Tax is only charged on profits, i.e., the money left over after you’ve paid/accounted for business overheads and other expenses.

Income Tax

In the tax year from 6 April 2023 to 5 April 2024, the standard Personal Allowance (the annual income that an individual can earn tax-free) is £12,570. Income Tax is then applied at the following rates to earnings above that amount:

  • 20% (Basic rate) – £12,571 to £50,270
  • 40% (Higher rate) – £50,271 to £125,140
  • 45% (Additional rate) – Over £125,140

If your total take-home income is more than £100,000, your Personal Allowance will decrease by £1 for every £2 earned above that figure. This means your Allowance will be zero if your annual income is £125,140 or more.

You can view current and previous Income Tax rates and Personal Allowances online.

National Insurance Contributions (NIC)

In addition to Income Tax, employees and their companies must make Class 1 National Insurance contributions on earnings above a certain level.

On your director’s salary, you will pay 12% NIC on earnings above £12,570/year (NIC Primary Threshold) up to £50,270/year (Upper Earnings Limit). The rate is reduced to 2% on any income above the Upper Earnings Limit.

Additionally, your company must make employers’ National Insurance contributions at a standard rate of 13.8% on your salaried income above £9,100 per year (Secondary Threshold).

You can view current and previous NIC rates and thresholds for employees and employers online.

What taxes are paid on dividends?

Directors who receive dividend payments are liable to pay Income Tax on any payments above the £1,000/year dividend allowance. The rate of tax will vary on the individual’s income tax bracket. However, the tax rate applied to dividend payments is lower than the equivalents for salary payments, with the current rates as follows:

  • £12,571 to £50,270 (Basic rate) – 8.75%
  • £50,271 to £125,140 (Higher rate) – 33.75%
  • Over £125,140 (Additional rate) – 39.35%

Companies pay Corporation Tax on profits and cannot deduct dividends from the tax bill. As a result, the government offers a tax-free dividend allowance and lower rates of dividend tax to shareholders.

More information about tax on dividends is available from HMRC online.

What taxes need to be paid on directors’ loans and expenses?

A director’s loan is essentially any money that you take from your company that is not a salary, dividend, or allowable expense. These loans can also work the other way around – by lending money to your company, for example, to buy equipment or to help with temporary cash flow issues.

If you end up with an overdrawn director’s loan account at the end of the company’s financial year, you may have to pay an S455 charge. Although such loans need to be paid back, they offer a chance for tax-free borrowing in the short term.

The Corporation Tax Return calculates S455 tax at a rate of 33.75% on the outstanding balance at the company year-end. You must pay this charge if you do not clear the loan account within 9 months of the company year-end. The director’s loan repayment will result in a refund of any S455 tax paid. Therefore, S455 is essentially a holding tax.

From a personal tax point of view, HMRC considers a director’s loan over £10,000 as a benefit in kind. If the company does not charge you interest on the loan or charges less than the official rate, HMRC will charge the official rate of interest to calculate the benefit in kind.

For 2023/24, the official rate of interest is 2.25%. Therefore, if a loan of £10,000 has been outstanding for 12 months, the benefit in kind would be £225.

Expenses come with different tax liabilities, and some are tax-free (e.g., certain childcare costs). Guidance on expenses and benefits for employers is available online.

What is the most tax-efficient way to pay me?

Company directors can achieve maximum tax efficiency in their compensation by blending salary, shares, and dividends, and by utilizing tax exemptions and directors’ loans and expenses.

The key lies in taking advantage of any personal allowances and tax-free options whilst at the same time minimizing Corporation Tax and legally avoiding other company liabilities where possible.

The most tax-efficient approaches for company directors will vary depending on the kind of circumstances and the tax rates and bands for the year, but the basic approach is as follows:

Step 1 – Salary

Multiple directors or business groups with more than one employee

In companies with at least two employees, the directors can take a salary of £12,570 and claim Employment Allowance (see below). This approach will avoid Income Tax liability whilst at the same time enabling the salary to be deducted from company profits, thus lowering the Corporation Tax bill.

The directors will not pay any Class 1 employee NIC because their salaries do not exceed the NIC Primary Threshold. However, the company might be required to pay Class 1 employer’s NIC on salary payments above £9,100.

Sole directors with no other employees

In companies where there is a single director and no employees, the Employment Allowance cannot be claimed. Therefore, the most tax-efficient approach will be to take a salary up to the Secondary Threshold. This is £9,100 per annum. This will avoid employee and employer’s NIC altogether.

Alternatively, you could pay yourself a salary up to the NIC Primary Threshold of £12,570 per annum. This is also the limit of your tax-free personal allowance. This is marginally less tax efficient because the company will be required to pay the employer’s NIC on the salary income between £9,100 and £12,570.

Please note: Only paying up to the NIC threshold can be tax efficient. The reason is not the right thing for everyone. Remember, to get the full State Pension on retirement. You need to have made a total of 420 qualifying months of National Insurance contributions or credits.

While you can choose to make voluntary contributions. it is a lot easier to just have your contributions up to date by making regular payments via PAYE.

So, if someone is anticipating the state pension as being a significant source of income on retirement. The reason is it may be preferable to take a salary up to the Income Tax threshold.

Step 2 – Dividend payments

Draw dividend payments of at least £1,000. Beyond the tax-free dividend allowance of £1,000, it is best only to take what is necessary and leave the remainder in the business as retained earnings.

The dividend tax will be lower than the tax paid on an equivalent salary. This is because the rates are lower than the corresponding Income Tax rates, and there is no NIC to pay.

Remember that dividends do not qualify as a business expense, unlike salaries. Keep in mind that the tax paid on dividends is still lower than the combined tax on Income Tax and NIC rates. It’s important to note that if an individual has other investments that receive dividends, they may have already used their £1,000 dividend allowance, which is subject to a tax rate of 8.75%. So, be careful and check all investments for dividend payments, as you may already have used all or part of your tax-free allowance.

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