by Martin Dunne - Thursday, 20th November 2008 -

Real Business agony uncle Martin Dunne is the answer to all your accounting woes. Each week he will tackle another problem faced by entrepreneurs. This week: salary vs dividends.

Q: "What is the most tax-efficient way to pay myself through my company - salary or dividends?"

A: First of all, assuming you have no other income, you should always take a basic salary equal to the annual tax-free personal allowance limit (currently £6,035). Where you do have other income, the salary amount should be adjusted downwards accordingly.

In a small company (for tax purposes, one where your Corporation Tax rate is 21 per cent), it is generally more tax-efficient to draw any other income from the company as a dividend rather than as a salary or bonus. For companies paying a higher rate of Corporation Tax, a salary or bonus is usually more tax-efficient than a dividend.

Having said that, this is an area that is attracting increasing attention from HM Revenue & Customs (HMRC), who are starting to challenge companies where directors take a nominal salary combined with very large dividends. HMRC will argue that a salary of £6,035 is not commensurate with the role and duties performed by a director, with the result that some of the dividend will be treated – and taxed – as salary.

In practice, I generally advise my clients to work out the minimum monthly income they need to live on, to pay the rent, utility bills, basic food costs and so on (for example, £1,000 a month after tax) and to take that as their salary amount. They can then take dividends twice a year to draw down any income they need over and above this.

This has two main advantages. Firstly, it enables you to draw enough money out of the company’s bank account every month to cover your basic outgoings and commitments. Secondly, it means that while you're paying a little more tax than you would be on a salary of just £6,035, HMRC are much less likely to identify your company as one to attack for having an artificially low salary level.

It is also important to consider pension contributions which can be made by the company directly to the individual’s pension scheme. These are easily the most tax-efficient way to draw money out of a company as there's no tax liability for the individual, and the company should obtain full tax-relief on the payment made.

Martin Dunne is a partner at Sayers Butterworth LLP. He previously worked in the entrepreneurial services division of Ernst & Young, and has over 15 years of experience working with fast-growing, entrepreneurial businesses. He provides practical and commercial advice to clients ranging from start-up stage to AIM-listers in a variety of sectors including retail, property, manufacturing, technology and media.

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