Probably the most common financial planning error business owners make is failure to draw a salary. It’s easy to understand why.
Many entrepreneurs live off savings during the start-up phase and never establish a system for paying themselves consistently, so they live on takings from the business which are grossed up for tax purposes.
Many businesses have irregular income, so their owners take dividends or director’s fees when profits allow, but don’t have a regular salary.
This practice may satisfy personal cash flow needs on a year-to-year basis, but it has considerable long-term downsides if your financial planning extends beyond the end of the accounting year - which of course it should. In fact, business owners who don’t pay themselves a salary are missing out on a major remuneration opportunity and probably paying more than they should in taxes.
The chief reason for a business owner to draw a salary as a PAYE worker is to create service for tax purposes. That is because the ability of the company to fund the owner’s pension depends on the length of remunerated service. No salary, no service, no pension. And you don’t even have to make regular contributions. By taking even a small salary, a business owner creates the option to fund a pension retrospectively out of company resources. Without doing this, a business owner forfeits one of the most efficient tools in the planning toolbox for managing both personal and corporate taxes.
Termination payments are also based on years of remunerated service, so you can dramatically increase the tax-free element of a lump sum payment by increasing remuneration in the event of a sale, if the company goes out of business or is liquidated.
Salary also represents an opportunity to remunerate family members who make bona fide contributions to the business. Putting family on the payroll preserves their rights to a pension and termination payments, too, and expands the scope to fund family wealth accumulation as a business grows in profitability. This can be a powerful mechanism for growing overall family wealth from a business.
What about those other ways of paying yourself? Generally speaking, remuneration in the form of salary, bonuses, BIK and directors’ fees is favoured – in that order – for both personal and corporate tax reasons. Dividend is the least attractive form of payment because it attracts dividend withholding tax and cannot be deducted against corporation tax. So from both a business efficiency and personal flexibility point of view, distributing profits pre-tax (i.e. before dividends) makes the most sense.