In the eternal debate on the best way for contractors to pay themselves, limited company contractors can still maximise their earnings (post tax) by paying a lower salary to themselves and then taking the balance of their pay via dividends from the profits of their company. There was some doubt as to whether this would remain the case after the tax hike on dividends that was adopted in April 2016, but it is still the most tax effective, mainly because those dividends are still not subject to NIC’s (National Insurance Contributions.) In addition to this, when the spouses of contractors have become shareholders in the contractor’s limited company, the contractor is also able to make full use of that spouse’s tax allowance. This can be done by both splitting the basic salary as well as splitting their limited companies dividend income so that they can reduce their combined tax liabilities even further and then maximise their net income.   

Ok, How Do Contractors Pay Taxes Then?

Contractor salaries work in a similar way to most people’s salaries. If the salary that the contractor pays themselves is over their personal allowance (which in 2016/17 was set at £11,000) then the part that is over their personal allowance is classed as taxable income and it will have income tax rates applied to it. (Not everyone will have a personal allowance of £11,000 as it will vary according to the tax code their tax profile has been assigned.) After that, their first £32,000 of that taxable income will then be subject to 20% basic rate income tax. And once the taxable income goes over the £32,000 limit, then a higher rate of 40% is applied in tax, all the way to £150,000. And finally, any income that goes over the £150,000 cap is taxed at a rate of 45%.

How Are Contractor NIC’s Calculated?

As well as this, employees (and we include limited company contractors in this category because they are classed as employees of their own limited companies) will have to pay HMRC an additional 12% of their gross earnings in NIC’s (National Insurance Contributions.) This 12% is paid on any earnings over £155 (per week) all the way up to a weekly rate of £827. At anything over £827, the NIC’s rate will drop down to just 2%.

With all these different tax rates and National Insurance contributions, it is easy to see why contractors have for a long time kept their salaries low!

What Are Employer’s National Insurance Contributions?

However, there are more taxes to consider. The limited company of the contractor must additionally pay employer’s national insurance contributions at a rate pf 13.8% on the amount of their contractor’s earnings which has been taken as salary and which is in excess of £156 (per week.) This is paid by the employer, which in the case of a limited company contractor is the limited company. This is another reason why contractors keep their salaries at low rates – not only do they minimise their employees contributions but it also helps minimise their employer’s contributions too!

What Happens If A Contractor’s Annual Income Goes Above £100,000?

Finally, there is one additional stealthy tax to weigh up. If a contractor’s annual income goes over £100,000 then their personal allowance decreases. This is calculated as follows – each £2 that the contractor earns over the £100,000 limit will see their personal allowance reduced by £1. So, if a contractor earns more than £122,000 then that personal allowance will be reduced down to nothing. This is bad enough but for every £2 that they earn from £100,000 to £122,000 they will be paying the aforementioned rate of 40% and then an additional pound is also being taxed at 40% now as they lose that allowance. In the end, this means they are being hit for an effective tax rate of 60%!

Ok, Then What About Dividends? How Are Dividends Taxed?

Dividends are the way that companies are able to distribute their profits out to their shareholders. Provided that the company is profiting, it is allowed to declare dividends at any time of year. Any attempt to declare a dividend if it is not in profit is defined as an illegal dividend, and problems will follow. How can a limited company make sure it doesn’t do this? By calculating its profits correctly – this is done by simply deducting any of the business outgoings  (including salaries and accountancy or insurance bills for example) from the total fee income. Thereafter, the company must deduct corporation tax at 20% out of the profits. Once this has been done the balance left can then be distributed as dividends to the shareholders of the company (which in the case of contractors will be the contractor themselves and also sometimes the spouse of the contractor.)

In addition to this, there is also a tax-free £5000 dividend allowance. It is not an allowance in the traditional sense of the word when it comes to tax. Instead, it is a zero rate band which comes out of the usual income tax bands (£32,000, £150,000 etc) mentioned above.

As an example, imagine that a contractor’s personal allowance has been fully used on a gross salary of £11,000 whilst the rest of his / her salary is taken out in dividends. The next tax band for the contractor will be at the basic rate up to £32,000. In this band, dividends will be taxed at a rate of 7.5%. However, within that band, the first £5000 will not be taxed at all, thanks to that £5000 dividend allowance. This means that in effect only £27,000 of the total £32,000 will actually be taxed at a rate of 7.5%. And after that, income from dividends that comes in the higher rate band (between £32,000 and £150,000) will be at a much higher rate of 32.5%. Similarly, any dividends that come in the band above £150,000 will be hit at a rate of 38.1%. However, dividends, in general, do not attract any employer national insurance contributions.

Salary and Dividends – A Comparison.

At a most basic example, any contractor who takes the minimum salary of £8000 and then takes the rest in dividends will easily pay a lot less national insurance and tax than contractors who are paying themselves simply through a salary, simply because the NIC’s have been minimised.

Within the limited company, once the corporation tax has been paid at 20% on gross profits, a contractor who was taking out dividends would only be required to pay an additional 7.5% on their first £27,000 worth of divided earnings falling within that basic rate cap, taking into account the dividend allowance. This would work out to be £2025. Therefore it quickly becomes obvious that it is advantageous to go down the lower salary and dividends road in order to get the most income and pay the least tax.

How To Use Your Personal Allowance and Your Split Dividends

As discussed above, any contractor who shares his or her limited company ownership with their spouse or partner will be able to benefit from their spouse’s tax allowances (if that spouse has no other income) through ‘income splitting.’ The contractor can assign 50% of their shares to the spouse whilst keeping 50% themselves. The dividends would then be paid out with both the contractor and the spouse getting 50% each.

What this means is that because the personal allowance and dividend allowance of the spouse are there to be used, contractors can in effect have twice the allowances. Post-corporation tax, contractors and spouses could take something like £10,000 of dividend allowances with their limited company in addition to their personal allowances without having to pay extra in NIC’s or tax, simply by going for the dividends and lower salary option. After that, they could go on and take out an additional £27,000 each while still on that basic 7.5% rate. 

Lastly, What About Settlements Legislation and IR35?

Of course, if there is a way for people to reduce their tax burden there is also probably a way for HMRC to try and stop them doing so! Thus did sharing company ownership and company dividends briefly become a controversial issue. HMRC tried to tackle this income splitting by going back to the settlements legislation in which income earned by the spouse of the contractor would be treated as if it were the income of the contractor and would be taxed similarly. This attempt was thwarted, however, when HMRC lost the test case, known as the Arctic Systems case. HMRC went on to draft some legislation to tackle income splitting but never brought it to law.

On the other hand, IR35 legislation was introduced in 2000 and has been on the books ever since. This legislation, designed to tackle disguised employment has been the bane of contractors ever since and has been getting stricter and stricter. It is the most important legislation for limited company contractors to get their heads around and anyone assessing the merits of different ways of working for tax purposes should also spend time assessing whether they might be within IR35.