There are three ways to draw money from a limited company: director’s loan, salary, dividends. Unlike a sole trader, a director is not allowed to just take money from the company bank account.

 

 

There are pros and cons for each way of drawing money, and in reality most directors use a combination of the three.

 

Directors’ Loan

 

Pros:

If the owner has put in a lot of capital in the business – cash, assets, inventory, etc., this can be accounted as a directors’ loan – loan from the Director. The director can draw money from the company without tax effect until the account becomes overdrawn.

 

If the loan is less than £5,000 and is repaid within 9 months and 1 day from the end of the accounting period, there is no tax due.

 

 

Cons:

If the director owes more than £10,000 at any time of the year, it is treated as ‘benefit in kind’ – tax free loan to the Director. Therefore, HMRC will assume the beneft is the foregone interest. Interest will be estimated at the HMRC interest rate – 3.25% and PAYE and Class 1 NI (around 26% will be charged on the interest).

 

 

If the loan is not repaid within 9 months and 1 day from the end of the accounting period, the company must pay 25% tax. The tax but not interest can be reclaimed when the loan is repaid.

 

 

If the loan is written off, Class 1 NI is due on the loan amount.

 

 

If the company goes bankrupt, the loan must be repaid.

 

Salary

 

Pros:

Paying NI ensures a state pension.

Salaries and employee benefits are tax deductible, therefore there is a corporation tax saving.

Pension contributions don’t incur income tax up to a very high limit.

 

 

Cons:

High rates of income tax (20% up to £31,785, 40% from £31,785 to £150,000, 45% above £150,000)

NI is payable up to 26% in total for employers and employees NI

 

Dividends

 

Pros:

Lower tax rates (effective tax rate of 0% for basic tax payers, 22.5% for high rate taxpayers, 30.56% for higher rate tax payer).

 

After April 2016, the dividend tax credit is replaced with £5,000 tax free allowance. The tax rates also increase to 7.5% for basic rate tax payers, 32.5% for high rate tax payers, 38.1% for higher rate tax payers.

 

No NI is payable on dividends.

 

 

Cons:

Payable from profits after tax, therefore no corporation tax saving.

 

In reality, a combination of Directors’ loan, salary and dividends is used to draw money from the business.

 

 

Example:

For example, a company makes £100,000 of pre-tax profits and the director wants to draw all profits. The director doesn’t have any other income.

 

Note that the calculations below are made with the new dividend and corporation tax rules and limits, coming in place from April 2016.

 

 

Example 1

 

All £100,000 is taken out as dividends.

 

Corporation Tax is £19,000

Net Dividend = £81,000

 

 

Income Tax

 

£5,000 tax free allowance on dividends   =  Nil

£11,000 tax free personal allowance        =  Nil

£32,004 @ 7.5% basic rate                          =  £2,400

£32,996 @ 32.5% high rate                         = £10,724

NI contributions (EE & ER)                           =  Nil

 

Total£32,124

 

 

 

Example 2

 

 

All £100,000 is taken as salary. This will include employers’ NI. Therefore the gross salary to the director will be £88,857.

 

 

Corporation Tax = Nil

 

 

Income Tax

 

£11,000 tax free personal allowance = Nil

£32,004 @ 20% basic rate                =      £6,401

£45,853 @ 40% high rate                  =   £18,341

NI contributions:

 

ER NI                                                     =    £11,143

EE NI                                                     =       £5,048

 

Total                                                       =   £40,933

 

 

Example 3

 

 

£100,000 taken as a mix of salary and NI.

 

 

Take £11,000 as salary. No PAYE is due, as the salary matches the tax free personal allowance.

 

 

Corporation Tax

 

Due on profit less salary and ER NI = £16,834

 

 

Income Tax

 

£11,000 tax free personal allowance = Nil

 

NI contributions

 

ER NI = £399

EE NI = £353

 

Distributable profits = £71,767 = dividends

 

Income Tax

 

£5,000 tax free allowance on dividends        = Nil

£32,004 @ 7.5% basic rate                               = £2,400

£34,763 @ 32.5% high rate                            = £11,298

 

Total                                                                   = £31,284

 

 

This is the lowest tax bill. Therefore, for a director with no other taxable income, taking out a small salary and the rest as dividends seems optimal.