Contractors’ most tax efficient salary and dividend levels, 2017/18

Here's our guide to limited company tax planning covering 06/04/2017–thru–05/04/2018. It highlights contractors' optimal salary and dividend levels split for tax year 2017/2018.

Storyboard:

• Introduction: defining the contractor role;
• (Roughly) how the payment vehicle works;
• This is how basic limited company tax efficiency works;
• Personal allowances for income tax, 2017/18;
• Taxes applicable to dividends for the 2017/18 tax year;
• Optimal salary for single- and multi-person payroll;
• • Don't feel pressured into a tax planning strategy if it's not for you;
• Drawing dividends at higher tax bands: three safe steps you can take;
• • Optimal spousal dividend distribution;
  • Buy-to-Let Property Investment;
  • Limited Company Pension Contributions;
  • Other means of saving on tax, situation specific.

Introduction: defining the contractor role

Income Tax for limited company contractors, freelancers and small business owners can get complicated.

So before we go into figures for this year, let's remind ourselves of the basics.

For brevity, I'll label all independent professionals who'd use a limited company payment structure as a 'contractor'.

If you're an incorporated freelancer or sole trader with a similar payment structure, this applies to you, too.

In most instances, the contractor is the main shareholder in their limited company. They don't have to be the sole shareholder. In fact it's common for a spouse or significant other to also own shares.

But it's the contractor who undertakes the labour and earns the main income. They're (often) also the director of the company.

(Roughly) how the payment vehicle works

So, first, clients pay all income into the contractors' payment vehicle, their limited company.

From there, the contractor will take a small, nominal salary. The rest of their income they'll extract as dividends or leave in the company.

It's this 'split' that contractors can optimise for tax planning efficiency. Or, in reality, their accountant or umbrella company will work it out for them.

Any income left in their limited company goes under the moniker "retained profits". How contractors extract these profits, as share certificates, helps to distinguish them from employees.

Rest assured, there's nothing illegal about it. What I'll outline here is a tax planning strategy familiar to many, adopted by millions, but with 2017/18 figures.

This is how basic limited company tax efficiency works

The contractor will pay themselves only a minimal, "tax efficient" salary. That salary won't exceed their personal allowance, thus leaving them exempt from personal tax.

That said, the salary will be enough to kick in national insurance payments, though. This ensures no gaps in national insurance continuity, despite being self-employed.

Paying NICs also entitles the contractor to state benefits, such as a pension in later years.

As salary, this part of their remuneration is deductible against tax. This saves corporation tax (19% for 2017/18) on gross salary.

Any other payments extracted from the company must be as dividends. The tax thresholds for dividends that contractors can draw are what we'll discuss later.

Just one final note here: dividends aren't liable for national insurance. But they're not an expense to offset against tax either. So dividends won't save limited companies any corporation tax, but salary will.

Okay. With me so far? Great. Let's look at the numbers.

Personal allowances for income tax, 2017/18

For 2017/18, the Chancellor increased workers' personal allowance to £11,500. In real terms, that means £11,500 of your contract or dividend income is tax-free.

For example, imagine that your company director's salary was your only income. You can calculate income tax on any salary you earn like this:

• up to £11,500 of what you earn is tax-free;
• on income between £11,500 and £45,000, you'll pay tax at 20%;
• earnings above £45,000, the higher tax band, will incur tax at 40%.

More tax thresholds and anomalies exist, some of which I cover here further on. But for illustration now, I'll use simplistic figures to give you an overview of how it works.

Taxes applicable to dividends for the 2017/18 tax year

The revised dividend allowance lets shareholders draw the first £5,000 tax-free. Beyond this threshold, your accountant will tax your dividend income as follows:

First, the good news. If you've not used all your personal allowance, up to £11,500, you can 'carry it over' tax-free. So, if your only income is from dividends, you could receive £16,500 of tax-free dividend income.

That figure derives from your £11,500 personal allowance added to the £5,000 dividend allowance.

Next, there's the basic tax band, which for 2017/18 is between £5,000 and £45,000. Any dividends in this range attract a tax charge of 7.5%.

Up a level, above the £45,000, then dividends become subject to 32.5% tax.

That is until you get to £150,000, where 36.1% is the levy for dividends above the upper tax band.

Rates can get even higher if your income triggers other certain variables. Child benefit charges at £50k or £100k personal allowance clawback threshold, for example.

Optimal salary for single- and multi-person payroll

HMRC has withdrawn the employment allowance for one-person payrolls. Now, the optimal salary for single-person payrolls is £8,160 per annum. In round figures, that's £680 pcm.

It's £680 because this figure will help contractors remain below the NICs Primary Threshold. For 2017/18, you begin to pay National Insurance when your income hits £157/week.

But, £680/pcm will also see you over the Lower Primary Threshold. This ensures you qualify for state pension and benefits in the future.

If there are two or more people on the payroll, e.g. husband and wife, the annual allowance is £11,500.

The optimal tax position for limited company contractors is akin to previous years. It still makes sense to draw a dividend that takes you up to—but not beyond—the higher rate tax threshold.

Where contractors (or their spouse) receive other income, they should reduce the optimal dividend. The aggregate income then should not exceed the higher rate tax threshold of £45k.

Thus, the optimal positions for payrolls, single or more than one, is as follows:

Don't feel pressured into a tax planning strategy if it's not for you

Savvy contractors should make themselves aware of these tax thresholds. Upon seeing them, most will choose to restrict dividend drawings. This will ensure they don't slip into the £45k higher band.

Any remaining income they'll leave in the business as retained profits. That's what we mean by "optimal tax strategy".

But some contractors may not have that choice and may need to get at their retained profits. Lifestyle choices and/or expenses will dictate how they access and spend their income.

Getting the balance right is key to staying tax efficient, but still enjoying the contractor lifestyle.

So let's be clear: tax efficiency is a personal choice. No one will hold you to ransom if your drawings take you into the upper tax band. Well, maybe apart from the tax man.

Drawing dividends at higher tax bands: three safe steps you can take

For many contractors, high, sustained income will tip them into higher tax bands. Retained profits will still exceed their optimal drawings level, despite any strategy.

So what choices do these contractors have to optimise tax breaks?

The biggest challenge remains how to extract those retained profits from the company. How do they get at their cash without footing an eye-watering bill from HMRC?

The following options we know to be tried, tested and—above all—safe.

1. Optimal spousal dividend distribution

You can distribute your dividend between you and your spouse. You knew there was a reason you married them, right?

Both you and they have personal allowances and the basic rate tax band to use. Make sure you do.

When your married spouse has received little or no income, the calculation's straightforward. Each partner can draw up to £45k giving a total net drawing of £90k per annum.

But when either of you has a separate income source, it's a bit different. You must reduce the optimal salary and dividend to suit. In this case, make sure that the aggregate income per taxpayer does not exceed £45k.

2. Buy-to-Let Property Investment

With investment choices limited, buying property to rent out is a common contractor strategy. With retained profit just sitting in their limited company, it's a tempting option.

And let's face facts: there's a shortage of residential rental property out there. Using retained profit to begin building a property portfolio isn't just tax-savvy. It's also helping to house tenants who'd otherwise have to wait a little longer. Win, win.

But contractors can benefit even more by buying their properties through their limited company. This circumvents the problem of facing a huge tax bill for extracting profits to fund the project.

Several lenders specialise in lending to limited companies to fund buy-to-let investments. Demand, as already noted, is also high enough to ensure competitive interest rates.

Ownership of property investment through your limited company has other benefits. It gets around some of the recent negative changes to taxation on rental income.

The government now restricts interest relief on rental properties for higher-rate taxpayers. That came in on 6 April (2017), so getting the right buy-to-let mortgage is essential.

Our guide to buy-to-let investment for contractors explores this option in more detail.

3. Limited Company Pension Contributions

Employers can contribute up to £40k each year to an employee's personal pension scheme. As a limited company contractor, you are an employer. And, yes: you can choose to fund your pension through your company, too.

It gets even better for those who've not used this strategy before. You can carry any unused pension allowance forward for up to 3 years. Where you've not used the allowance in the previous years, you can make a single contribution of up to £120k.

The recent relaxation of the pension rules has also helped. You're no longer forced to buy an annuity. There are now no restrictions on the amount of your pension fund that you can withdraw as a lump sum after age 55.

Employer pension contributions are generally treated as a tax-deductible expense for the company. They're not treated as a contractor's taxable income or drawings. Rather, they reduce the company's corporation tax liability.

These circumstances have made funding a pension through their company more attractive to contractors.

Other means of saving on tax, situation-specific

There are other ways to reduce salary and dividend tax liability. Directors' loans, members' voluntary liquidation and taking on more shareholders to name a few.

These are not without risk, both from profitability and tax avoidance perspectives. While they may save on liability, their suitability will depend on your specific situation.

If you're close to retirement or looking to get back into an employed role, liquidation may be an option. As with all these 'other means', your situation will dictate your strategy. Hence, your accountant is best placed to give you that advice.

I hope you found the tax planning strategy and advice here invaluable. Here's to you, your bottom line and, of course, the tax man, without whom none of this would be possible. Cheers!