Contractor tax: how do I pay myself via my Limited Company?

It’s easy to imagine that compared to finding and undertaking contracts, managing your accounts, wrangling with suppliers and dealing with all the other minutiae of running your own business, taking home your hard-earned money should be a no-brainer.  Up to a point, this is true.  However, if you hope to realise the full benefits of setting up your own limited company then you need to understand the different options for getting your cash out of your company’s bank account and into your pocket and select a payment model that makes the most of the current tax regulations.

Employer and Employee

As the director of your limited company, contractors are treated as an employee for tax purposes.  The practical upshot of this is that you must register with HMRC to use PAYE to pay your salary – full details can be found on the HMRC website. 

As your own employer, you will need to deduct income tax, Class 1 (Employer’s Contributions), and Class 4 National Insurance contributions, or NICs, from your salary, and forward these to HMRC monthly (or possibly quarterly if the amounts are low enough).  Clearly, maximising your company’s profitability means keeping these outgoings as small as possible.

Contractor Tax and the Take-Home Balancing Act: Salary v. Dividends

The commonest solution is to pay yourself using a mixture of salary and dividends, keeping the salary low would minimise the amount of NICs you have to pay (dividends do not qualify for National Insurance).  Exactly where you place the split between these two types of income must be carefully calculated to ensure that you get the best return. The level of salary you draw is dictated by other factors too, such as pension requirements, and therefore your accountant is the best person to recommend. Some things to consider:

-While a low salary means lower income tax and NICs, it also means higher Corporation Tax (as your salary is deducted from your company’s turnover before Corporation Tax is calculated).

-You can only take dividends out of your post-Corporation Tax profits, i.e. from the money you have actually earned, whereas a salary can be paid out of future earnings (e.g. by borrowing money from your bank).  If you pay yourself too small a salary, relying on a monthly dividend to cover your living expenses, then a lean month could leave you short of cash.

-If HMRC consider that your contractor/client relationship is actually a disguised employer/employee arrangement (i.e. caught by IR35), then you will not be able to receive dividends and will have to pay full employer’s and employee’s NICs on the whole of your income.

These are the bare bones of the considerations you will need to take into account when selecting the best payment model for your limited company.  Other factors to consider include what to do with any funds left in the company’s bank account come year end, and how best to handle the situation if you are not the only employee or shareholder.  It’s essential you get expert advice, as every company is different and only up-to-date knowledge of the tax system can give you the tailored solution that ensures that you get the best possible return for your efforts.

Doug Brett-Matthewson