Director Compensation: Balancing Salary, Dividends, and Contractual Obligations for SMEs

For small and medium-sized enterprises (SMEs) in the UK, determining the most tax-efficient and legally compliant method of director compensation is a critical consideration.

The primary avenues for director remuneration are salaries and dividends. Each has distinct implications under English employment law and HMRC guidelines. The landscape of employment law and tax policy is evolving. Understanding the potential consequences of substituting salary with dividends is more important than ever. This is especially true when directors have employment contracts specifying standard working hours.

Understanding Salaries and Dividends

Salaries are regular payments made to directors as employees of the company. They are subject to Income Tax and National Insurance Contributions (NICs) under the Pay As You Earn (PAYE) system. Salaries are considered allowable business expenses. This reduces the company’s Corporation Tax liability, providing a clear advantage from a business expense perspective. However, salaries attract NICs from both the employer and the employee. This increases the overall tax burden on the company.

Dividends, on the other hand, are paid to shareholders from the company’s post-tax profits. They are not subject to NICs, making them a tax-efficient method of remuneration. However, dividends can only be paid if the company has sufficient retained profits, and they must be distributed according to shareholding proportions. Importantly, dividends do not count as wages for the purposes of meeting the National Minimum Wage (NMW) requirements.

The UK economic environment has influenced director remuneration practices significantly. The 2024 report on director remuneration in FTSE 250 companies showed a slowdown in C-suite salary growth. Companies are opting for more flexible remuneration strategies amidst economic uncertainty. While large corporations might have the flexibility to adjust remuneration packages, SMEs must tread carefully. This is crucial to avoid regulatory pitfalls, particularly concerning NMW compliance and tax efficiency.

The employment law landscape is also evolving, with the government considering reforms to enhance worker protections and transparency in pay structures. There is increasing scrutiny from HMRC, particularly concerning disguised remuneration schemes and the correct classification of director payments. As the government seeks to increase tax revenue, it is likely that enforcement around NMW compliance and the proper use of dividends in lieu of salary will intensify.

For directors with employment contracts specifying standard working hours, such as 9 am to 5 pm, Monday to Friday, receiving only dividends instead of a salary can lead to significant legal and financial risks. Employment law requires that employees, including directors, receive at least the NMW for all contracted hours. Dividends cannot substitute for salary in this regard, and any shortfall may result in backdated pay claims and penalties. Non-contracted officeholders are not subject to national minimum wage rules.

In addition, misclassifying remuneration can lead to discrepancies in tax reporting. HMRC has the power to investigate and impose fines for non-compliance, including penalties up to 200% of any underpayment of NMW and public “naming and shaming” of the business. Moreover, without a salary that contributes to NICs, directors may lose entitlement to certain state benefits. This impacts long-term financial security, including pension entitlements.

Looking Forward: Tax Policy and Compliance

The tax landscape in the UK is expected to tighten further as the government aims to balance the books following significant public spending in recent years. Potential changes could include stricter rules on dividend payments and further measures to prevent abuse of tax-efficient remuneration strategies. SMEs should anticipate possible adjustments to dividend tax rates and Corporation Tax rules. This may affect the attractiveness of dividends as a compensation strategy.

To mitigate these risks and remain compliant, SMEs should adopt a balanced approach to director remuneration. It should combine a reasonable salary with dividends. This ensures compliance with NMW regulations while leveraging the tax efficiency of dividends within the bounds of the law. Accurate record-keeping, especially regarding board minutes and dividend declarations, is essential. It demonstrates transparency and compliance if scrutinized by HMRC.

Best Practices for SMEs

SMEs should ensure that employment contracts accurately reflect the nature of directors’ roles. This includes clearly distinguishing between their duties as employees and as shareholders. Professional advice from accountants or employment lawyers can help tailor remuneration strategies to the specific circumstances of the company. This ensures they align with both current laws and anticipated regulatory changes.

As the regulatory and economic landscape evolves, being proactive and informed will help SMEs manage director compensation effectively. This balancing compliance with tax efficiency and safeguarding the company from potential legal and financial repercussions.

Our employment and corporate law teams can advise you on best practice for director agreements and remuneration.