Jennifer Adams looks at situations where paying a bonus may be preferable to taking a dividend.
Directors can extract monies from a company in various ways, the choice invariably being between a salary or dividend (should the director also be a shareholder); but there may be circumstances that might compel payment via a bonus.
The choice of which method can only be determined by comparing the net amount received after all taxes and National Insurance contributions (NICs) charges have been paid.
Bonus payments
As with salary payments, a bonus is subject to income tax and NICs for the recipient and employer’s NIC for the company (subject to the employer’s allowance). The difference is in the timing of the bonus payment. For directors, payment is the earlier of the following dates:
- When a payment is made.
- When the director becomes entitled to the payment.
- When the earnings are credited to the company accounts.
- Where the amount of earnings is determined before the end of the period to which they relate, then the date is the date the period ends.
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Where the amount of earnings is determined after the end of the period to which they relate, then the date is the date of determination.
Therefore, a bonus payment can be related back to the previous accounting year. If that year shows low profits, this would produce a reduction in those profits, resulting in a lower tax liability or even creating a loss with a tax refund out of which at least part of the bonus could be paid.
Dividend payments
In comparison, the relevant date for tax purposes of an interim dividend is the actual date of payment. For a final dividend, the date is that of a general meeting, unless a later payment date is specified in the resolution.
The main ‘downside’ to paying a dividend is that it must be paid out of distributable profits. Therefore, if no profit has been made or there are no or insufficient undistributed profits brought forward from previous years, generally no dividend can be paid. By contrast, a bonus can be paid whenever, even if this results in the company making a loss.
Where distributable profits are available, care is still required as any dividend paid in excess of distributable profits or out of capital is ‘ultra vires’ and, in effect, illegal (termed an ‘unlawful dividend’). A further problem with a dividend payment is that it cannot be paid to one shareholder in preference to another, or paid to each at a different rate (unless there is a dividend waiver or an alphabet share structure in place).
Should a company find itself in any of these situations, declaring a bonus may be the only way to withdraw funds.
Practical issues
Pension contributions remain the most tax-efficient way of extracting profits from a company, not least because employer pension contributions do not attract NICs and they are also an allowable deduction for corporation tax purposes. In addition, making pension contributions is another reason for declaring a bonus, as dividends are not treated as ‘earnings’ for pension contribution tax purposes.
A bonus can also be more tax-efficient where the director-shareholder has other tax deductions or reliefs available, for example:
- income tax losses;
- EIS investments;
- VCT investments; and
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tax-allowable interest payments.
Practical tip
Extracting funds via dividends requires retained profits. A company cannot generally make a distribution out of capital, and should the profit be insufficient to enable payment but a distribution is still taken, the director-shareholder may be liable to repay either in cash or the equivalent value in other assets.
