Date posted: 21st Nov 2022
Many owner managed businesses will have a simple approach to remuneration planning – a small salary with dividends meeting income requirements.
In a lot of cases this can be tax efficient, but that is not always the case, especially with reliefs such as R&D etc.
We have seen rises in dividend tax rates in recent years and with a recession looming on the horizon, is it time to consider how you draw monies from your limited company?
But a salary attracts national insurance….?
Yes that is an issue – the director and the company will both pay national insurance on any associated salary costs.
But of course both the salary and employer’s national insurance are deductible costs for the company, when calculating corporate tax. Corporate tax is set to rise from April 2023, so the company may receive further tax relief on the employer’s national insurance.
Dividends are not tax deductible costs – these are paid out of after tax profits, so there is no corporate tax relief on dividends.
In addition, increasing dividend income tax rates are narrowing the benefits of taking the “usual” remuneration package and there may be commercial issues to consider, going forward.
What is the commercial issue….?
For a company to pay dividends to shareholders, it needs to make a profit. This could be profits in that particular year or indeed historic profits.
However, take the case of an owner managed business where the director-shareholder has drawn all of the profits as dividends each year.
Facing the prospect of a recession, how profitable will the company be going forward?
Will it be able to pay a large dividend to the director?
Or will the “dividends” voted, have to be repaid to the company?
As ever, such quandaries are best demonstrated with an example.
Example
Joe Bloggs is the sole shareholder of Joe Bloggs Plumbing and Heating Limited.
The company year end is 31 December each year and Joe likes to do his accounts before the end of the tax year to ensure that there is enough time to vote any dividends ahead of the end of the tax year.
Each year, Joe takes a salary of £12k – £1k per month and then another £4k per month as a “loan” which will be repaid by voting a dividend, once the accounts are finalised.
The company usually makes £60k profits (after Joe’s salary) and pays £12k tax – leaving £48k of after tax profits on which Joe votes a dividend to himself – essentially just clearing his overdrawn loan account. No reserves are left in the company for future dividends.
Let’s say that this continues and he continues to draw £5k per month – £1k salary and £4k in dividends.
Whilst, 2023 has been tough and cash has been generated, Joe has delayed paying his creditors to allow him to continue to draw £5k per month and live his usual lifestyle. He doesn’t see this as an issue as he knows that 2024 will be “his year.”
However, once the 2023 accounts are drawn up, in March 2024, these show that the profits are only £10k (after tax), meaning that there are not enough reserves to vote a dividend to repay his £48k directors loan. A dividend of £10k is voted, which means that Joe faces tax issues on the loan of £38k.
2024 continues in a similar vein and the company is unable to meet its debts, as Joe is drawing the cash rather than paying the company’s debts. Joe’s overdrawn loan account continues to increase with little profits to vote a dividend. Joe decides to close the company.
However, at the point at which Joe decides to close the company, he is one of the biggest debtors of the company due to his loan account. Any liquidator is likely to therefore ask Joe to repay the loan to the company, so that the liquidator can settle with any creditors. Joe, of course, does not necessarily have many thousands to repay to the company. Joe is therefore going to have to sell something (his home, car, investments etc) to repay the loan.
Had Joe taken a salary, then this amount could not be clawed back by a liquidator, as easily, as long as the amounts were not unreasonable. So yes, Joe may have saved a small sum of tax by taking dividends rather than salary historically, but it could cost him a lot more in the future by not at least considering remuneration planning in a recession.
Calculations
It is important to undertake a review of your own circumstances and carry out calculations to determine the tax saving on the difference between taking a pure salary against a hybrid salary-dividend calculation.
In our very simple calculations, someone earning a £50k salary would have a net income of c£37,600 for 2023/24 and would save c£3,700 of tax using this smaller salary/dividend remuneration strategy. But given the issues faced by Joe (in the example above), then is such a saving worth the risk if your business is struggling and you have to repay the dividends to a liquidator?
