UK Fact-File Part 2:
Individual Business Domestic Taxation

2.14 UK Individual Business Tax-Efficient Profit Distribution

Choosing between dividends, salary and fringe benefits

A mix of salary, benefits in kind and dividends is probably the most tax-efficient way of rewarding directors of a limited company, no matter the size of the company. By drawing a salary, the company will pay the tax and national insurance contributions for the director, who is classed as an employee of the company. These will be deducted from gross salary, which is tax deductible for the company.

Benefits in kind might include a car, mobile phone or medical insurance. The individual will often be taxed on the benefit in kind, but the costs borne by the company are tax deductible. The extent to which this is an efficient method of remuneration will depend on the nature of the benefit in kind and the individual’s circumstances.

Dividends are tax efficient, as national insurance contributions are not payable by either the individual or the company.
A sole trader running a small business can pay a wage to his or her spouse, maximising the use of each individual’s personal tax allowance. However, care must be taken here to ensure that the spouse is playing an active part in the business, as HMRC has tightened the rules recently on the apportioning of income from the company, requiring a significant degree of participation from both spouses to back up any tax efficient allocation of profit.

Depending on the level of income, a sole trader will pay personal income tax – from 20%, to up to 41% at the top level of earnings. From April 2010, a 50% top rate has been put in place for earnings over GBP150,000. For a limited company, corporation tax can be lower when compared to the top level of personal income tax (currently 21%-28%, although these rates are set to be reduced by 1% each in April 2011) so it is worth considering whether a limited company represent a better option than working as a sole trader.