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For small and medium business owners, every penny counts. Often, this leads many well-meaning business owners to reduce or even forgo their own salary for the overall good of the business. While this is undoubtedly noble, it doesn’t make a great deal of business sense in the long term. Indeed, business owners should be paid for their hard work just like any other employee.

One way to mitigate the impact of this is to seek out the most tax efficient way of paying yourself a salary. In the vast majority of cases, this is done by issuing dividends. Put simply, this is a share of a company’s profit which is paid out to shareholders and owners, based on their stake in the company. Importantly, this can only be done after all other expenses and corporation tax liabilities have been paid.

Issuing dividends is a little bit trickier than paying normal salaries. First, you have to hold a meeting of the company directors to formally ‘declare’ a dividend. Then you issue a voucher to the recipient, which gives the specific details of the dividend.

So how does this help?

The key to understanding why dividends are more tax efficient is what’s known as your ‘dividend allowance’. This is the amount you can earn in dividends without having to pay any tax at all. In 2019/20, this is £2000. Crucially, this is completely separate from your personal income tax allowance of £12,500.

Even once you’ve exceeded your £2000 tax-free dividend allowance, this continues to be more tax efficient. This is because the standard tax rates are lower for income generated by dividends than that which comes from your normal salary. For example, the basic income tax rate is 20% for any salary earned between £12,501 and £50,000. The rate you pay on dividends between £2001 and £37,500 is only 7.5%.

Indeed, all tax bands on dividends are lower than their standard income tax counterparts. As such, the key to making your income as tax efficient as possible is paying yourself with the perfect balance of dividends and your normal salary. That’s where an expert accountant can become invaluable.

Photo: Money by 401(K) 2013 licensed under Creative commons 5