Aug 6, 2023

How to Pay Yourself a Salary as a small business owner in the UK in 2023

Self-employment offers a myriad of benefits compared to traditional options: flexibility, entrepreneurship, and freedom, to name a few. Of course, owning a small business is a labour of love—but it can also provide substantial profits while you invest time into what you’re passionate about.

While your small business brings in money, you also need to make something to cover your expenses, from groceries to your mortgage. As the owner and operator of your business, you are tasked with paying yourself as with any of your other employees.

There is more than one way to pay yourself as a small business owner. The options reviewed below vary in tax procedure and what your year-end payment routine will look like and should be reviewed with an expert. Making the right choice in this regard is crucial both for your business and your needs as a self-employed individual.

How To Pay Yourself As A Small Business Owner

Self-employed small business owners traditionally have two popular routes: functioning as a sole trader, wherein your business income is considered personal income, operating as a partnership or limited company.

In the first method, your income is straightforward and comes in what is considered a “business drawing.” These business drawings are taxed at the same rate as your personal income would be, and are considered, indeed, personal income.

When operating a business as a partnership or limited company, however, you can pay yourself via a salary as well as dividends that are dispersed to all shareholders.

The best method to pay yourself depends wholly on what type of business you run–and the classification of such.

Paying Yourself As A Sole Trader

Operating as a sole trader is the most straightforward and flexible way to pay yourself as a small business owner. Establishing yourself as a sole trader is a must if you meet any of the below criteria:

Your self-employed income for the previous tax year exceeded £1,000
You need to prove your self-employment status to participate in benefit programs
You voluntarily would like to make Class 2 National Insurance payments to assist with benefit qualifications

If any of them sound like you, but you aren’t ready to enter a partnership or limited corporation, then you should establish yourself as a sole trader.

As a sole trader, all of your business income is considered your personal income—there is no separation between yourself and your business, from a legal perspective. This makes tax payments relatively straightforward, as you’ll only need to inform HMRC that you pay tax through Self Assessment. You’ll need to file a tax return for yourself each year.

When it comes time for taxes, you’ll owe a bill on the money you made in profit as your income. Again, as a sole trader, this is the same as the total income for the business.

Pay Yourself a Salary

This is a more common method for small and medium business owners to pay themselves, especially if the business is paying taxes as a corporation or partnership separate from the individual. More or less, you pay yourself just like any other employee: You register yourself as an employer, and you submit Income Tax and National Insurance from your own salary. Your business then classifies your salary as labour costs when it comes time for corporate taxes.

One stipulation of paying yourself a salary versus filing as self-employed is that you must pay yourself a comparable salary to someone else performing your duties in a similar capacity within your industry. This can stretch your business thin when you’re not performing well and cause a loss. It also means that you may not be able to liquidate your equity as quickly or easily as in a sole proprietorship using the owners’ draw method.

When it’s time for taxes, your personal and business taxes will be separate. You pay your personal taxes according to your salary as well as any dividends. Then your business files its taxes as a separate entity.

Even though you pay yourself a salary and must contribute to National Insurance, you are still considered as a company Director. HMRC can collect your National Insurance in two different ways: once a year or every month. To contribute every month, you must select the alternative calculation method in your payroll software. It’s up to you to decide which calculation method is best for you.

How to set up as a sole trader and prepare your self-assessment tax return in 2023?

Guide to setting up as a sole trader in the UK. Learn about HMRC registration, tax returns, and key insights for starting your business journey successfully.

Which Self-Employed Payment Method Is Right For Me?

Weighing these options is nothing to take lightly, but your accountant can help break down your choices and select the one that makes the most sense for your situation.

Some things to consider:

The stage of your business
Your business type (sole trader, partnership, limited corp, etc.)
Your tax situation

Your business type is a major limiting factor in terms of your self-employed payment method, as many types of businesses are explicitly required or excluded from using certain types of self-payment. If you’re a sole trader, you don’t need to pay yourself, as the money you make through the business is all considered personal income. A partnership works in a similar manner, though one designated partner must file the taxes for your business.

If you operate as a limited liability partnership or limited corporation, you may have more than one type of income. If you register your business as an employer, you can pay yourself a salary in line with the standard rate for your position within your industry. This money is typically tax deductible for your business as labour costs.

You can also pay yourself dividends—a percentage of your profits that are distributed to shareholders—though these are not typically regarded as tax-deductible for your business. Anything else you draw from your corporation is considered a “Directors’ loan” and different tax rules will apply.

Pros And Cons Of Being A Sole Trader

Different self-employed payment methods have different pros and cons. When it comes to the owners’ draw, assuming you’re eligible under tax laws to take one, there are some appealing advantages:

Taxes are paid annually, allowing you to invest and budget as you see fit.
Money can be withdrawn as needed, making money available to you as personal funds in a pinch, or allowing you to keep more money in your business to assist in growth.

This is by far the most flexible method by which to pay yourself, and may be the most simple approach for sole proprietors. However, this method does have some disadvantages as well:

It can be difficult to budget, due to irregular withdrawals and no tax withholding.
You may pay more taxes, depending on your situation, since everything will be taxed personally.

Pros And Cons of Paying Yourself A Salary

While this method is more popular for a number of reasons, it’s important to reflect on both the benefits and disadvantages of paying yourself a salary.

Benefits:

Easier to budget, as your salary is a regular, recurring business expense you can count on.
Taxable income is typically lower, given that your salary is taxed at a personal rate and deducted as a business expense on corporate income tax.

Disadvantages:

Limited access to your money, including equity you have in the business.
Inflexible fund payout can lead to business drains as you must pay yourself regardless of whether the business is doing well or poorly.

‍

Step by step process

‍

1. Decide on a reasonable salary

The first step in paying yourself a salary as a small business owner is to decide on a reasonable amount. This should be based on your business's financial situation, as well as your personal financial needs. You should also consider the industry standards for salaries in your field.

2. Determine your business structure

The way you pay yourself will depend on the structure of your business. If you are a sole trader, you will be taxed on your business profits. If you have a limited company, you can choose to pay yourself a salary or dividends. You will also need to register as an employer with HM Revenue and Customs (HMRC) if you have employees.

3. Understand your tax responsibilities

As a small business owner, you will be responsible for paying income tax and National Insurance contributions on your salary. If you have a limited company, you will also need to pay employer's National Insurance contributions. You will need to register for self-assessment with HMRC and file a tax return each year. You may want to consider hiring an accountant to help you with this.

4. Choose a payroll system

To pay yourself a salary, you will need to choose a payroll system. This can be a manual system or a software system. You will need to keep accurate records of your salary payments, as well as any tax and National Insurance contributions deducted from your salary.

5. Set up a bank account

To pay yourself a salary, you will need to set up a separate bank account for your business. This will make it easier to keep track of your business finances and ensure that you are paying yourself a salary in a consistent and reliable way.

6. Pay yourself regularly

To ensure that you are paying yourself a salary on a regular basis, it's a good idea to set up a schedule. This can be weekly, biweekly, or monthly, depending on your needs. Make sure that you are paying yourself a reasonable amount and that you are keeping accurate records of your payments.

Takeaway

The two main methods of paying yourself as a small business owner, whether by salary and dividends or as a sole trader, have different benefits and disadvantages to consider. When deciding which method is best for you and your small business, it’s important to consult with your accountant or other tax professional. Small business taxes don’t have to be complicated—but your decision should be informed to provide the best possible results for you and your business.