Best way to pay myself from my company when my marginal tax rate is higher than the company tax rate?

Question

I'm working as an IT contractor in Australia and I'm about to move from a sole trader model to a Ltd company. I'm trying to work out the most tax effective way of paying myself in my own company, for which I am the only employee.

I've heard it's some balance between paying myself a salary and paying myself dividends. I followed the "Ricardo" example on this site:

https://www.moneysmart.gov.au/investing/shares/keeping-track-of-your-shares/dividends

I understand that if your marginal tax rate is lower than the company tax rate of 30% then you will get a tax refund to make up the difference, but it doesn't seem clear what would happen if your marginal tax rate is higher than the 30% company tax rate:

"If Ricardo was in a higher tax bracket he may not have been entitled to a refund of any of the franking credit, he may even have to pay additional tax."

It seems a bit vague. Would I have to pay the extra tax on the dividends, or would the tax I pay be capped out at the 30% which was already paid before the dividends were handed out? If it's not capped at 30% is there any benefit from splitting my income into salary and dividends at all, seeing as I would pay the same amount of tax in total anyway? Is the only advantage that I'm not forced to pay 9.5% superannuation on the total income but just on the salary itself?

Answer 1

The total dividends is the franked dividend plus the franking credits, also called the grossed up dividend. You can compare the grossed up dividend from a company that pays franked dividends (dividends from company profits where company tax has already been paid) with the dividends paid from a company that pays unfranked dividends (dividends from company profits where company tax has not been paid yet).

Basically you will pay tax on the grossed up dividends at your marginal tax rate. So you would get a tax credit for the 30% company tax and then pay tax at your marginal tax rate. Franking credits are just there to stop someone paying double taxation on the dividends (both company tax and individual tax).

So if your marginal tax rate is at 45% then you would receive a credit for the company tax rate already paid and pay 45% on the total grossed up dividend. Effectively the company pays 30% tax and you pay an additional 15% tax on the grossed up dividends.

By paying more into super you can actually pay less tax overall, as concessional contributions into super are only taxed at 15% compared to the 30% company tax rate and up to 45% individual tax rate. So if your aim is to lower your tax then one possible solution would be to max out your concessional contributions into super (currently $25k).