Here’s the Freelancer Financials’ guide to limited company tax planning covering 06/04/2017 thru 05/04/2018. It highlights contractors’ optimal salary and dividend levels for tax year 2017/2018.
- Introduction: what distinguishes contractors from employees?
- 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;
- Drawing dividends at higher tax bands: three safe steps you can take;
Introduction: what distinguishes contractors from employees?
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, we’ll label all independent professionals who’d use a limited company as ‘contractors’. If you are an incorporated freelancer or sole trader, I offer my apologies in advance. Moving on.
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 – generally – also the director of the company.
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.
Any income left in their limited company goes under the moniker “retained profits”.
The way in which contractors extract these funds helps to distinguish them from employees.
Rest assured, there’s nothing illegal about it. What we’ll outline here is tax planning strategy familiar to many, adopted by millions.
This is how basic limited company tax efficiency works
The contractor will pay themselves only a minimal salary. That salary won’t exceed their personal allowance, so leaving them exempt from personal tax. Hence the term “tax efficient”.
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 is 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 English, that means £11,500 of your contract or dividend income is tax free.
For example, let’s say that your company director’s salary was your only income. You can calculate income tax on any salary you earn, thus:
- 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 our illustration now, we’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, good news. If you’ve not used all your personal allowance, up to £11,500, it ‘carries 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 claw back 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 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) receives 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:
|Single person payrolls, optimal salary/dividend spread 2017/18:|
|Income Type||Annual Total (up to Threshold)|
|Two or more person payrolls, optimal salary/dividend spread 2017/18:|
|Income Type||Annual Total (up to Threshold)|
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. Seeing them, most will choose to restrict dividend drawings. This will ensure that 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. They may well need to access their retained profits. Lifestyle choices and/or expenses will dictate how they access and spend their income.
Here, getting the balance right is paramount to staying tax efficient and enjoying life.
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 eyewatering bill from HMRC?
The following options we know to be tried, tested and – above all – safe.
Optimal spousal dividend distribution
You can distribute your dividend between you and your spouse. They’d got to be good for something one day, right? Today’s that day.
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 problem’s less acute. Each partner can draw up to £45k giving a total net drawing of £90k per annum.
But when you or your spouse has another income, 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.
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 start building an empire 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 we’ve 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 the 6th 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.
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 relaxation of the pension rules has also helped. You are 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 the age of 55.
Employer pension contributions are generally treated as a tax deductible expense for the company. Neither are they 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 accountant is better placed to give you that advice.
For the contractors looking to optimise their income over time, thanks for dropping by. 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!
Author: John Yerou
John Yerou is the owner and founder of Freelancer Financials; a trading style & trade mark of the award winning Mortgage Quest Ltd. One of the most recognised names in providing mortgages for contractors and freelancers across the UK.
In 2004 John began his career in Financial Services as an independent mortgage adviser and broker. John has been instrumental in negotiating bespoke underwriting for contractors with high street lenders.
His presence in the industry as a go-to expert is growing by the day and he is regularly cited and writes in publications both locally and nationally.