It is possible to set up a limited company and for the directors to receive a small taxable salary and to share some or all of the remaining profits by the payment of dividends.

A self employed individual will pay Income Tax and National Insurance Contributions (NIC) on their taxable net profits (less a deduction for capital equipment expenditure). A limited company will pay Corporation Tax on its taxable net profit (less capital expenditure) which will be calculated after charging directors’ salaries.

For 2008/9 the Income Tax rate after the Personal Allowance (of £5,435) is 20 per cent up to £41,435 and then at 40 per cent whereas the Small Companies Corporation Tax rate is 21 per cent (up to £300,000). But self employed individuals are also levied NIC at 8 per cent on taxable profits between £5,435 and £40,040 and 1 per cent above, but companies do not pay NIC on dividends.

It is generally beneficial to ensure that the salary each director receives exceeds the minimum level required to qualify for state benefits. Directors are exempted from the requirements to be paid the National Minimum Wage provided they are “genuinely self-employed”.

Care must be taken that the company has made sufficient profit to pay the dividends. If a dividend is paid in excess of the profits available, the excess has to be repaid by the shareholders. One other caution – dividends do not qualify for calculating for tax purposes the maximum payable into a pension i.e. only the salary element can determine the maximum payment.

Dividends are deemed to have suffered a 10 per cent tax deduction, but if the dividend pushes the individual director into the higher rate tax band (on incomes exceeding £41,435 in 2008/9) tax is payable at 32.5 per cent, less the deemed 10per cent, so at an additional 22.5 per cent rate. Care should also be exercise as to any taxable benefits enjoyed by directors (should as health insurance or use of company cars) as they can cloud the remuneration calculation.

You should talk to your accountant about the mechanics of this. Many accountants provide payroll services to help with the calculations of director’s salaries, PAYE and NIC payable and the timing of dividend payments.

See also: What small businesses need to know about dividend tax changes