There are several ways that directors can be paid by a limited company, for example by salaries and, if they are also a shareholder, through dividends. It is therefore important to ensure that how a director is paid is in the most tax effective way.
If a company has made a profit after paying all its costs, liabilities and taxes in a financial year, it can distribute this amongst its shareholders through the payment of a share dividend. Dividends can be paid from the previous year’s retained profits or from the profits of the current financial year with any profit that is not distributed among the shareholders remaining in the company’s business bank account.
In general, dividends are distributed according to the number of shares a shareholder has. As an example, a shareholder who holds 30% of the issued share capital will be entitled to receive 30% of the dividend, i.e. the profit that is being distributed.
Although in recent years the level of tax payable on dividends has increased, nevertheless this remains the most tax efficient method of paying a director who is also a shareholder because no National Insurance contributions are deductible from dividend payments and the tax rate is lower than that applicable to a salary
To calculate how much dividend you can earn as a director who is also a shareholder, firstly the net profit that the company has available must be calculated by adding the current profit to the retained profit. This total figure is the maximum amount that can be distributed as a dividend payment although it should be born in mind that the company with have ongoing liabilities to meet such as leases and loans for which there must be sufficient funds to meet.
Although limited companies generally make dividend payments at the end of the financial year, such payments can be made at any time providing a meeting of the directors has been held at which the payment of dividends is agreed. The minutes of this meeting, which must be taken even if there is only one director, should include the date of the meeting, the amount of the dividend payment and the date on which payment will be made.
Having decided how much the dividend will be and when it will be paid, a dividend voucher must then be created which should include:
Each shareholder who will receive a dividend must then be given a copy of the dividend voucher with a copy also being retained within the company’s records.
Providing dividend payments do not exceed the profits that the company has made, these can be made at any time at the discretion of the owners of the company although, for ease of accounting, it would be advisable for these payments to be paid regularly – eg monthly, quarterly or annually. Directors who are also shareholders should maintain separate salary and dividend payment records.
The company is not liable for tax on any dividend payments it makes but the shareholders who receive dividend payments may be liable to pay tax on these depending on how much they receive and their own personal tax situation as indicated by completion of their annual self-assessment tax return.
For the tax year 2019/2020, there is a dividend allowance of £2000 which means that the first £2000 of dividend payments that a shareholder receives is not liable for any tax deduction. In addition, each individual taxpayer currently has a £12,500 personal allowance which is also not subject to any deduction of tax. However, once the £12,500 personal allowance threshold has been reached, there are other considerations
Company directors who are also shareholders often draw a low salary that keeps their earnings below the £12,500 personal allowance level because after this has been reached, any salary would be taxed at the current basic rate of 20% which rises to 45% when the next higher level of income threshold is reached.
So, having taken a low salary, a director who is also a shareholder can then draw additional earnings in the form of dividend payments. Using the example of a director who is also a shareholder who wishes to earn £50,000, the best way to achieve this, assuming the company has made sufficient profit, would be:
This means that all the director has to pay in tax is £2662.50 (i.e. 7.5% of £35,000) representing a net income of £47,337.50.
However if the director who is also a shareholder were to take £50,000 as a salary alone, then there would be more tax to pay:
This means that the director would pay total tax and NI contributions of £12,464 resulting in a net income of £37,536.
As well as the obvious benefits as demonstrated by the examples above, consideration should be given to certain risks that this payment strategy entails.
Being paid a salary means that contribution can be paid into a personal pension although if the majority of a director’s income is made up of dividend payments, then the company could set up its own pension scheme into which money could be paid by the director.
Whilst each shareholder will be entitled to a dividend that is payable at a fixed rate per share, obviously not all shareholders will contribute the same amount of work and commitment to the company. This being the case, different classes of shares can be issued that carry different dividend rights, as well as voting rights, which means those who do the most work can be rewarded with a higher dividend.
Being a share of the profits of a company, obviously dividends should only be paid when that company makes a profit. It is therefore illegal for a company to make dividend payments in the knowledge that the company has either traded at a loss or has made insufficient profit. Such payments are referred to as ultra vires dividends. It is also a legal requirement for companies to produce a dividend voucher and for the process of the authorisation of dividend payments to be recorded in the minutes of the relevant board meetings.
If a director who is also a shareholder does take a dividend payment that the company cannot afford to pay, then this may result in a significant overdrawn director’s loan account, i.e. money taken out of the company that is required to paid back within nine months of the financial year end. If this money is not paid back into the company then, as far as HMRC is concerned, this must be deemed to be income and there will thus be tax and NI contributions to be paid on that amount despite the fact this was originally a dividend payment.
Should the company be forced into a formal insolvency process then any money in the overdrawn director’s loan account must be repaid to the company for distribution to its creditors and the director may also face allegations that the company has been wrongfully trading which could result in the director being prohibited from acting as a company director for up to 15 years.
As salaries are deducted as a form of expense on a company’s profit and loss account, any salary payment will reduce the amount of profit the company makes and thus the amount of corporation tax due. Dividend payments do not affect corporation tax liability.
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