Employment Status as a Director, and Understanding Salary Payments

There are many reasons as to why sole traders decide to incorporate their businesses and continue their entrepreneurial journey through a limited company. For some further in-depth details on that, you may find our article on 'Changing from a Sole Trader to a Limited Company' helpful. However, if you are the director a limited company either as a recent start up or after changing your company trading status to incorporated, you need to consider whether you are an employee and the implications this has for tax for the company and you personally.

Employment Status

In employment law, a person's employment status helps determine their rights, their employer's responsibilities, as well as tax due on income. The main types of employment statuses are:

Worker: A person is generally classed as a 'worker' if they have a contract or other arrangement to do work or services personally for a reward (money or benefit in kind). Workers occasionally do work for a specific business and their contract with the business uses terms like 'casual', 'freelance' or something similar.
Employee: A person who works under an employment agreement; all employees are workers, but the main distinction is that employees have extra employment rights and responsibilities.
Self-employed and contractor: A person who runs a business for themselves and takes responsibility for its success or failure; self-employed workers are not paid through PAYE (Pay As You Earn), and therefore they do not have the rights and responsibilities of an employee. Self-employed people are responsible for paying their own National insurance (NI) and tax. Someone can be both employed and self-employed. Contractors can be self-employed, have the employment status of a worker, or have the employment status of an employee.
Director: Company directors run limited companies on behalf of shareholders; they have different rights and responsibilities from employees and are classed as 'office holders' for tax and National Insurance contributions.
Office holder: A person who has been appointed to a position by a company or organisation but does not have a contract or receive regular payments. They are neither employees nor workers, however if there is an employment contract with the same company, someone can be both an employee and an office holder.

Directors have different employment rights that they are entitled to, and those will depend on the director's role and employment status. This area is very complex as the director can be employed, self-employed or a worker. Notably, in employment law a director of a limited has the status of an office holder. Self-employed people who convert their business to a limited company typically become directors of the company as well as employees of that company.

What is the Employment Status of a Director, an Employee, Self-Employed or an Office Holder?

There are several ways people run their businesses—as sole traders, as directors of limited companies or as partners in a partnerships. Typically, sole traders and individuals in partnerships are treated as self-employed for tax purposes.

On the other hand, directors of limited companies are not self-employed, as if they are paid by the company, this will have to be in the form of an employee salary or if paid a share of profits, then this will be through dividends.

There is often a confusion that once a limited company is formed, its director is both employed (as he can be paid an employee salary) and self-employed (working for himself), but this is not the case because for tax purposes a director is an office holder and if paid through the Company's PAYE (Pay As You Earn) system—an employee. As a new company starting out, often directors do not have the luxury of being paid by the company and often the directors end up loaning the company money.

How Can a Director Pay Themselves Through a Limited Company?

Directors have greater flexibility over how they pay themselves, and by that they can reduce the tax liability due on income. However, it is important to understand the legally acceptable ways of taking money out of a business after the company's incorporation as the company is a separate legal entity to the director. There is often confusion and directors make the mistake of thinking that they can take salary by transferring funds directly from their business—but this is not the case!

One of the most important points is that the director and the company are two separate entities, therefore, personal and business funds must be kept separately. There are four main ways a director can pay themselves:

i) Taking Salary Through PAYE

This means that the director is an employee of the company. In order to make salary payments, the company has to be registered as an employer with HMRC, as well as ensure that any tax and national insurance is deducted and paid to HMRC. For tax purposes, the salary is treated as earnings from employment rather than self-employment.

ii) Through a Director's Loan

If a director decides to take out a director's loan (withdrawal that is neither salary nor dividends); then this will have to recorded as a director's loan and there are some special rules that apply.

Director's loans are quite tricky and need attention, because HMRC classes them as a high risk area. If a director withdraws money from his limited company in the form of a director's loan, and the amount is not repaid by 9 months after the accounting period end date, the company will have to pay corporation tax at 33.75% on the loan. However, the company can reclaim the corporation tax it pays on a director's loan that has been repaid, written off or released.

However, many small businesses operate a directors loan account. This is where sometimes the business loans the director money and sometimes the director loans the company money. Tax is only payable if the director owes the company money at the end of the accounting period

iii) Deducting Dividends

Dividends are a distribution of a company's profit, dividends are subject to dividend tax. As a shareholder, the director is deemed to be the beneficial owner of the business and can receive his income in the form of dividends.

If a director decides to pay himself in the form of dividends, this will not affect the corporation tax payable the company has (if applicable) as dividends are not classified as business expenses. Companies can only pay dividends if there is sufficient capital (retained earnings) to do so. If the director receives dividends, then they are personally responsible for paying tax on those dividends and the amount of tax will depend on the level of income the person has.

iv) By Reimbursement of Expenses

In the case where a director has paid personally for wholly and exclusively business expenses, the amount can be repaid tax free; meaning that the company will be paying back for the business related expenditure. Any transactions between the company and director, where the director is paying for expenses for the company should be recorded in the directors loan account.

How Much Tax Do Directors Pay on Their Income?

Directors receive their income as company directors through Payroll minus National Insurance Contributions through PAYE, and the applicable tax rate will depend on the threshold in which the taxable income falls into. There are different rules for dividend payments as dividends are not subject to National insurance contributions and they are classified as investment income. Again, the tax due will depend on the amount of dividends paid out.

What are the Income Tax Rates and Allowances for the Tax Year From 6 April 2024 to 5 April 2025?

One of the main factors which should be taken into account when calculating a person's income tax, is the taxpayer's entitlement to any personal allowances, as well as the extra allowances available for blind taxpayers and older married couples.

For tax year 2024/2025 the applicable allowances are:

Personal allowance of £12,570* (this represents how much tax-free income an individual can have in a tax year)

Personal savings allowance for basic rate taxpayers of £1,000

Personal savings allowance for higher rate taxpayers of £500

Dividend allowance of £500

*Personal allowance of £12,570 is reduced by one-half of the excess if the taxpayer has 'adjusted net income' exceeding £100,000. However, if the taxpayer's net adjusted income is above £125,140 Personal allowance is £0.

Income Tax

Non-savings income tax rates for England and Norther Ireland

Tax rate	Rate of tax	Annual earnings the rate applies to
Basic rate band	20%	Up to £37,700
Higher rate band	40%	From £37,701 to £125,140
Additional rate band	45%	Above £125,140

Rates for Scotland

Tax rate	Rate of tax	Annual earnings the rate applies to
Starter tax rate	19%	Up to £2,162
Basic tax rate	20%	From £2,163 to £13,118
Intermediate tax rate	21%	From £13,119 to £31,092
Higher tax rate	42%	From £31,093 to £125,140
Top tax rate	47%	Reminder after £125,140

Tax rate	Rate of tax	Annual earnings the rate applies to
Starter tax rate	19%	Up to £2,306
Basic tax rate	20%	From £2,307 to £13,991
Intermediate tax rate	21%	From £13,992 to £31,092
Higher tax rate	42%	From £31,093 to £62,430
Advanced tax rate	45%	From £62,431 to £125,140
Top tax rate	48%	Above £125,140

Dividend Tax

The income tax liability on a individual's income from dividends is calculated in a different way from the liability on savings and non-savings income. Dividends have the first £500 as 'Dividend nil allowance', meaning that the first £500 of dividends are taxed at 0%. Tax is not paid on any dividend income if it falls within the Personal allowance of £12,570. Therefore, if you receive no other income other than £12,000 in dividends, then you would not pay any tax.

Band	Dividend tax rates
Basic rate	8.75%
Higher rate	33.75%
Additional rate	39.35%

National Insurance Contributions (NICs)

NICs are payable by employees, employers and by the self-employed. The class of National insurance will depend on the employment status and how much was earned in a tax period. For directors, the NICs are calculated for the whole of the tax year. For employees, NICs are calculated separately for each contribution periods and any salary an employee receives is subject to employee National insurance, however different rates will apply, depending on a weekly threshold. The annual threshold is £12,570 meaning that National insurance will be payable after reaching £12,570. However, the company would start paying employer NI on anything after £9,100.

To Summarise

Understanding the director's employment status can feel complicated, so here are the most important points to remember:

Separation between the company and the director—funds should be kept separate.
A company director is regarded as an employee for most statutory purposes if they have a service contract with the company.
Self-employed people run their business by themselves as sole traders or as part of a partnership, as opposed to employees who work under an employment contract.
In some circumstances it might not be clear whether someone is legally classed as an employee or worker, so it is important to work out their employment status.