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

The declaration of a dividend has for many years been a strategy adopted by many small businesses. In 2008 the Government announced they were going to introduce new rules relating to income shifting. In November 2008 they announced that they were deferring the introduction of new rules.

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:

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As mentioned above, income tax is chargeable on all profits withdrawn from a company.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 further income tax equal to 22.5% of the gross dividend, while an employee liable to the 50% rate of tax will be liable to pay additional income tax equal to 32.5% of the gross dividend. Thus dependent on the rate of tax payable the tax on dividends is either 10%, 32.5% or 42.5%.

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 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% (increasing to 13.8% from 6 April 2011) on all salaries above £5,715 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.

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 (40%). As this is above the national insurance normal upper limit, employees' contributions at 1% and employers' contributions will be payable.

	Tax rate 40%		Tax rate 50%
	Bonus £	Dividend £	Bonus £	Dividend £
Profit	10,000	10,000	10,000	10,000
Employers' national insurance	(1,135)		(1,135)
Salary available	8,865		8,865
Corporation tax on £10,000 @ 21%		(2,100)		(2,100)
Dividend		7,900		7,900
Income tax @ 40%	(3,546)
Income tax @ 50%			(4,433)
Employees' national insurance			(89)
Additional income tax		(1,975)		(2,853)
Net amount available	5,319	5,925	4,343	5,047

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 on 01708 854943 or http://www.truemanbrown.co.uk/.