What’s the most tax-efficient way for company directors to take income? Salary or dividends?

If you run a company, there are the three different ways that you can choose to pay yourself: salary, dividends and pension contributions. It’s important to get the structure of your income right, not only from a tax point of view as there are other considerations to think about as well.

Here’s an example of how I helped one of my clients establish the most appropriate way of paying themselves.

how to pay yourself at atm

About the company 

My client is a well established architects practice in London and they work on a wide range of projects with unique challenges. The company has two directors and employs around 30 employees. The practice has had varying levels of growth over the last few years, mainly as a result of the pandemic and the ongoing challenges in the economy.

The problem

The directors wanted to establish what the most efficient way of them drawing their income from the company was – they didn’t want to be paying more tax than they needed too, but because of their required level of drawings, the tax bills could have been pretty sizeable if we hadn’t of got it right.   The directors also wanted to look at this as they felt that it was easier to get mortgages if they were receiving salaries and regular payslips.

The position was complicated by the fact that the practice has a track record of making successful R&D claims and part of the cost of the directors could have been included in these, if we could establish that there was proven work carried out by the directors on R&D projects.

The calculation was more complex than a straight comparison between salary and dividends.

The solution

We developed a sophisticated calculator to work out the different amounts of personal tax that would have been due and compared the position between the director’s drawing salaries with varying percentages of R&D work and compared this with them taking dividends from the company.

We also facilitated discussions with a mortgage broker to provide reassurances about the availability of mortgages to individuals taking their income as dividends as this was a key concern of the directors.

The results

We established that if the director’s were spending at least 20% of their time on R&D work, this would have an effect of reducing their overall tax bills by around £5,000, and the savings would only have increased as the percentage of time spent on R&D work increased.   However, although the directors wanted their income to be as straightforward as possible and were leaning towards a PAYE salary, during a detailed discussion with them, we established that they didn’t spend anywhere near as much as 20% of their time on R&D work, mainly because the detailed design work on projects is carried out by their team of architects.

The discussions with the mortgage broker also provided reassurances that as long as the directors were using a mortgage broker that has access to the whole of the market and there was  plenty of time to deal with the application, there shouldn’t be any issues with getting a mortgage if they received dividends from a limited company (notwithstanding any other issues of course).

The directors have decided to draw their income as a combination of a small salary (below personal allowance) as this is tax free and keeps their state pension record up to date, with the balance being taken as dividends.   We’ve also made some tweaks to their management accounts to ensure that the directors are providing for the tax on the dividends that they are taking which will help to avoid any nasty surprises when their tax return forms are prepared.