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.
The declaration of a dividend has for many years been a strategy adopted by many small businesses.
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.
The main current considerations for choosing between salary and dividends are:
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.
As mentioned above, income tax is chargeable on all profits withdrawn from a company.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 further income tax equal to 22.5% of the gross dividend, while an additional rate taxpayer will be liable to pay additional income tax equal to 27% of the gross dividend. Thus dependent on the rate of tax payable the tax on dividends is either 10%, 32.5% or 37.5%.
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 12% on earnings between the earnings threshold and the upper earnings limit, and 2% on earnings above this without any upper limit. Employers pay 13.8% on all salaries above £8,060 p.a. without any upper limit.
Every business, charity and CASC is entitled to an annual 'employment allowance' of £2,000 to reduce their liability for class 1 secondary national insurance contributions. One claim only may be made for companies in a group or under common control.
Salaries can be paid even when a company is making a loss. Dividends may be paid only out of profits for the year, or any undistributed profits from previous years. It is important to ensure that the appropriate documentation and minutes are raised to support the dividend to ensure that this is declared legally and correctly.
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.
PAYE and national insurance are payable monthly; corporation tax is payable nine months and one day after the company's year end with the exception of a large company which will pay its corporation tax by quarterly instalments. 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).
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.
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 either the higher rate of income tax (40%) or the additional rate of income tax (45%). As this is above the national insurance normal upper limit, employees' contributions at 2% and employers' contributions will be payable.
|Higher Tax rate 40%||Additional Tax rate 45%|
|Employers' national insurance||(1,213)||(1,213)|
|Corporation tax on £10,000 @ 20%||(2,000)||(2,000)|
|Income tax @ 40%||(3,515)|
|Income tax @ 45%||(3,955)|
|Employees' national insurance||(176)||(176)|
|Additional income tax||(2,000)||(2,444)|
|Net amount available||5,096||6,000||4,656||5,556|
This example shows an overall saving of £904 (40%) or £900 (45%) 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.
From April 2016, the 10 percent dividend tax credit will be abolished and replaced with a new dividend tax allowance of £5,000 per year. New rates of tax on dividend income above the allowance will be introduced, which will be 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
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'.
Finally, it is important to be aware that the declaration of a dividend may have an impact on the valuation of the company's shares.
Do call us if you would like further help or advice on this subject.