Articles by Anna Loginova.
There are several ways a company can allocate the profits from the business to the shareholders – salary, drawings or dividends. However, clients are often uncertain about which option works better.
If you need a reminder about the difference between salary and drawings, have a read of our Drawings versus Salary blog from October 2021.
Firstly, there is no one-size-fits-all formula – what works best for your particular business depends on your circumstances. It can also change over time – a salary may be better one year, and drawings another, for example.
Let’s have a look at the options, on the assumption that we are talking about an individual (i.e. a natural person) shareholder of an ordinary company.
A PAYE salary will generally be the preferred option when:
• Business cashflow is steady and regular
• Profit is consistent throughout the year
• You prefer (or are happy) to manage cashflow so that you pay tax (PAYE) during the year
• There is no surprise tax bill at the end of financial year when the tax return is prepared.
• Salary is the preferred form of remuneration with banks and second-tier lenders (if you want to secure borrowing).
It is extremely important to set the appropriate amount of PAYE salary. It should not be more than the profit of the business, or the company will end up in a loss position.
Drawings are similar to a loan that the company provides to the shareholder during the year.
If business performance fluctuates a lot during the year, taking drawings if and when required may be the best option.
At the end of the year (or throughout the year), the company can allocate a salary to the shareholder, provided that the company has made a profit. This “shareholder salary” will be offset against the drawings taken during the year.
Converting the drawings into salary means the shareholder will need to pay tax on it, and this is done in three instalments during the year. In other words, a “shareholder salary” is not subject to PAYE.
Salary is based on the profit the company has made. The trick is to make sure that drawings do not exceed the salary that the company will allocate to you. Otherwise, the company will be required to charge the shareholder interest per Inland Revenue’s prescribed interest rate. This is because if interest is not charged, there is a deemed dividend to the shareholder. The company will then have will pay tax on that interest, which is an extra cost.
Taking drawings provides flexibility from a cashflow point of view, and the possibility to earn some interest on the funds that the company is holding or reinvesting in the meantime (funds which would otherwise have been paid to IRD in PAYE during the year).
If the shareholder’s current account is overdrawn (which means the shareholder took more drawings during the year than their allocated salary), a dividend can be declared to clear out their current account. If you don’t do this, the company would have to pay tax on the interest that it is obliged to charge the shareholder, and this can be costly.
Dividends are usually declared once a year and generally once the financial year is finished, so the actual position for the year and whether the company satisfies the solvency test can be determined. A company must be solvent before it can declare a dividend – for more explanation about solvency, click here.
Scenario 1 - Steady business: Maria runs an accounting practice with consistent monthly income. She takes a regular salary of $6,000 per month, paying PAYE throughout the year. At tax time, there are no surprises, and her bank is happy with her salary income for her mortgage application.
Scenario 2 - Seasonal business: Tom owns a tourism business that's busy in summer but quiet in winter. He takes drawings of $10,000 during each busy month and minimal amounts during quiet months. At year-end, his company made $100,000 profit and allocates him a $100,000 shareholder salary, which offsets his drawings. He pays tax on this in three instalments the following year.
Scenario 3 - Overdrawn account: Lisa took $120,000 in drawings, but her company only made $100,000 profit (so her salary is $100,000). Her current account is overdrawn by $20,000. If possible, the company should declare a $20,000 dividend to clear this, avoiding interest charges and the associated tax cost to the company.
If you would like assistance with determining the most appropriate option for you (salary, drawings or dividends), please get in touch with us at GRA.
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