Company Bonus or Dividend?

In many small companies, the owners are also the directors, and this gives considerable scope for deciding how profits should be taken out of the company.

Important

In view of the Government's intention to introduce new rules relating to income shifting, please contact us to discuss the implications relating to your remuneration / dividend policy.

Traditionally, small companies pay salaries to the directors and tend to ignore their second role as shareholders, which entitles them to receive dividends.

Where profits are retained within a company, the situation is governed by the corporation tax rules, but when you draw profit out, income tax rules take over, and national insurance rears its ugly head.

After HM Revenue & Customs lost the landmark case of Arctic Systems following a ruling by the House of Lords, the Government announced their intention to legislate to prevent individuals arranging their affairs to gain a tax advantage by shifting part of their income to another person who is subject to a lower rate of tax ('income shifting').

Draft legislation was published in December, which many people think is unworkable. An early Day Motion was signed by 174 MP's urged the Government to reconsider its proposals.

The Government has not backed down. It has announced it now intends to introduce legislation through Finance Bill 2009, and whilst it has said that the legislation will not be backdated to 6 April 2008, it could become effective from some later date such as the date of the Pre-Budget Report.

The main current considerations for choosing between salary and dividends are:

Corporation tax

This is charged on the profits of the business after taking into account all salaries. Paying a salary reduces profits and hence reduces the corporation tax bill.

Income tax

As mentioned above, income tax is chargeable on all profits withdrawn from a company. On salary, it is collected through the PAYE system. A dividend carries with it a 10% tax credit, and for a basic rate taxpayer there is no further tax to be paid. A higher rate taxpayer will have to pay additional income tax equal to 22.5% of the gross dividend.

National insurance contributions

National insurance contributions are payable on salaries, but not on dividends. There are two elements - employee contributions and employer contributions. Employees pay 11% on earnings between the earnings threshold and the upper earnings limit, and 1% on earnings above this without any upper limit. Employers pay 12.8% on all salaries above £5,435 p.a. without any upper limit.

Company law

Salaries can be paid even when a company is making a loss. Dividends can be paid only out of profits for the year, or any undistributed profits from previous years.

Other shareholders

Salaries can be allocated to different directors at any rate. A shareholder is entitled to a dividend in proportion to the number of shares held. This means that non-working shareholders would participate in any dividend declared.

This lack of flexibility can be countered by creating different classes of share with different dividend entitlements.

Cashflow

PAYE and national insurance are payable monthly; corporation tax is payable nine months and one day after the company's year end. Additional income tax on dividends is payable on 31 January after the end of the tax year in which the dividend is paid (payments on account may be required).

Pensions

Payments of additional salaries can enhance the contributions that can be paid to pension schemes. For certain types of scheme, benefits can be based on the pay for the best three out of the last ten years before retirement, so planning for high salaries can be used to advantage.

Income shifting

The Government has announced that it will introduce changes regarding income shifting which it advises will not be effective from 6 April 2008. The intention of this legislation will be to deal with their view that it is unfair that some individuals can arrange their affairs to gain an advantage by shifting part of their income to another person who is subject to a lower rate of tax.

The Government intend to consult further before announcing their intentions. These may well be announced in the 2008 pre Budget Report. However, this Government has a tendency to announce proposals at anytime.

Example

The details below illustrate the potential advantage of using dividends rather than a salary bonus to extract profits of £10,000 from a small company. The examples assume that the directors are already being paid salaries that take them into the higher rate of income tax. As this is above the national insurance normal upper limit, employees' contributions at 1% and employers' contributions will be payable.

	Bonus £	Dividend £
Profit	10,000	10,000
Employers' national insurance	(1,135)
Salary available	8,865
Corporation tax on £10,000 @ 21%		(2,100)
Dividend		7,900
Income tax @ 40%	(3,546)
Employees' national insurance	(89)
Additional income tax		(1,975)
Net amount available	5,230	5,925

This example shows an overall saving of £695 by paying a dividend. Care and professional advice should be taken in all cases. An individual's and company's specific circumstances must be reviewed and the advice tailored to the particular needs.

It is clear that many factors must be considered when deciding whether directors should be paid by dividend or salary/bonus. In practice, a mixture of each is usually the best course, subject to the impact of 'IR35'.

Do call us if you would like further help or advice on this subject.