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Are Dividends Best?

09 January 2012

If you are both a shareholder and director of an owner managed private limited company, you could extract the profits from your company in a number of different ways - but which one is best to minimise the overall tax payable?

Well, based on current tax legislation, if the company pays into a pension scheme on your behalf then these employer pension contributions are (within certain limits) the most tax-efficient way to extract profits from a company.  However, this does mean that these funds are locked away until retirement age.  Care also needs to be taken not to breach certain annual and lifetime limits.

So what about salaried bonuses or dividends as current income? Salaried bonuses suffer both income tax and national insurance liabilities (NIC) but the good news is they are normally tax deductible for the company.  Dividends on the other hand are not tax deductible for the company but (on the positive side) generally don’t attract any national insurance liability.  In recent years the rate of NIC for both employees and employers has increased and the rate of corporation tax has reduced.  This has led to salaried bonuses becoming less tax efficient with the result that dividends are often the most attractive method of extracting profits from a company (see example below for a higher rate taxpayer). 

Simple Example

Based on 2011/12 rates, in order to provide you, as a 40% taxpayer, with £10,000 cash in hand (after deduction of income tax/national insurance), a small company (paying tax at 20%) can:

Issue a dividend: 

   

£

     

Net (cash) dividend

13,333

Tax credit @ 10%

1,481

Income tax @ 32.5%

(4,814)

After tax dividend

10,000

     

Net cost to company

13,333

Issue a bonus: 

 

£

   

Bonus

17,241

   

Employer NIC @ 13.8%

2,379

less corporation tax relief @ 20%

(3,924)

Net cost to company

15,696

   

Income tax @ 40%

6,896

Employee NIC @ 2%

345

After tax bonus

10,000

As you can see, the overall tax saving from issuing dividends rather than a salaried bonus in the above example is £2,363.

The position for you personally can however be affected by levels of income received from sources outwith the company (eg from rental income, salaries from other employers or profits from self employments). Other non-tax issues also need to be borne in mind (some of which are mentioned below).  The best method of extracting profits from a company therefore very much depends on your own personal circumstances.

Other Advantages/Disadvantages of Dividends

Cashflow - As well as producing a tax-saving, dividends can also offer a cashflow benefit as income tax and national insurance on bonuses is collected through normal payroll procedures (usually monthly) whereas the tax on dividends is collected through the self assessment tax return (with tax usually payable on 31 January following the end of the tax year).  Again this will however depend on individual circumstances.

Legality - Dividends can only legally be paid if the company has sufficient distributable reserves.  If dividends are to be paid, the relevant board minutes and dividend certificates should be prepared.

Flexibility - While the amount of bonus paid to each employee/director can be varied commensurate to each individual’s performance, dividends can only be paid to shareholders and should be paid in proportion to their respective shareholdings. 

Spouses – Salaries and bonuses can only be paid to individuals who undertake work for the company.  Dividends however are paid on shareholdings and shares can be held by almost anyone.  Where a spouse pays tax at a lower rate, in order to reduce the couple’s overall tax bill, it may therefore be worth considering gifting shares to them.  Ongoing annual tax savings from doing so can, depending on the particular circumstances, exceed £10,000 per annum.  It is however important to consider both the capital gains tax as well as the income tax position.

Other Issues

Consideration should also be given to:

  • Use of personal allowances
  • Use of tax free basic rate band dividends
  • Effect on state pension and benefits
  • Effect on mortgage applications
  • Effect on quarterly instalment payments by large companies
  • Use of other tax efficient benefits such as childcare, ‘green’ company cars, mobile phones and working from home allowances.
  • Accumulation of profits within the company now for extraction as a capital gain on a future winding up of the company (potentially attracting a tax rate of just 10%).

 

The above article is intended as a general summary of current tax legislation.  Springfords LLP accept no liability for any loss arising from anyone acting on it.   Advice should be sought in relation to your particular circumstances.  For more detailed information on the above and/or calculations of the tax cost/saving of paying dividends instead of salaries, please contact pberry@springfords.com or your usual Springfords advisor.