Dividends v salary
In a small owner managed company, where the directors and shareholders are the same individuals, the issue of being paid a salary becomes more contentious in light of the fact that (for higher earners) the tax liability due on a salary payments is incredibly high when compared to most small business taxes. We refer to our page which deals with a company’s method of Accounting for Tax here.
For obvious reasons this can appear quite frustrating particularly where a director feels as if s/he is working for HMRC rather than for himself, with half of their hard-earned income (or more) being paid to the state.
Most companies will expend considerable effort on mitigating, or avoiding, this expensive tax expense but this can be dangerous where the necessary tax planning becomes avoidance, or a wilful attempt to avoid paying legitimate tax liabilities.
Alternate approaches to extracting income have been adopted by many individuals and their businesses in recent years using complex tax schemes in an effort to mitigate their exposure to income tax.
A common practice within small companies, to negate the problem of high income taxes (via the PAYE/NIC system), was to take a Director’s Loan and then to draw income as dividends at the year-end (with lower tax rates) or find some mechanism to write them off at a later date.
Whilst this practice is legitimate, the common occurrence of this (and often the writing off of such loans) led to the introduction of taxes due on director’s loans, which could only be recovered if the loan was paid back. This loan charge provides quite a disincentive for Director’s taking loans, where they had been accounting for such loans.
This can have severe consequences for Directors of companies which may face insolvency proceedings, as effectively they are often required to pay back what they have otherwise received as income over the final trading period of the company.
The more acceptable method for drawing income whilst mitigating taxes exists where the directors are also shareholders of the company, who can declare a dividend at the year-end and set this off against any outstanding director’s loan account balance.
Quite commonly directors of a small company pay themselves a salary via the PAYE/NIC system either up to the limit of their tax-free allowance or up to the limit of the lower band for PAYE/NIC.
A dividend of sums in excess of this carries a reduced tax rate, which is intended to encourage entrepreneurship and the growth of companies in the UK, but following changes in ongoing Budgets, the difference in recent years has become narrower.
Process of Declaring and Paying a Dividend
Whilst it is a mandatory legal requirement for a company to have distributable accumulated profits before a dividend is declared and paid to its shareholders, the Companies Act 2006 requires that a specific process is adopted for declaring a dividend, to ensure the directors have considered all of the company’s financial information and have jointly agreed to declare such a dividend, and to ensure shareholders agree the payment.
If this process is not adopted, despite having distributable reserves available for this purpose, the dividend will be void and technically repayable by the shareholders and/or directors (if they are deemed to have breached their fiduciary duties).
Where a company fails or does not make a profit, and loans have been made to Directors (with the intention of setting off a dividend declared at the year-end), the Director will have no entitlement to a dividend and may have to repay his/her director’s loan account or pay the taxes due on that loan account.
At Francis Wilks & Jones we are able to assist with any legal matters arising in respect of these problems, your potential defences to claims for repayment of such loan balances as a result of a claim by a liquidator or a claim for breaches of your fiduciary duties.
Please call any member of our Tax Disputes Team for your consultation now on 0207 841 0390. Alternatively email us with your query at email@example.com and we will call you back at a time convenient for you.