Paying A Bonus; Points To Consider

Jennifer Adams considers when a bonus may be a useful way to extract business profits.

As readers of Business Tax Insider are aware, funds may be extracted from a company in a variety of ways. For a director, the choice is invariably between the taking of salary or a dividend; but there are circumstances which might compel payment via a bonus. 

The method of extraction resulting in the minimal amount of tax being paid overall by the company and the director/shareholder is, as ever, dependent upon individual circumstances. The decision can really only be made by the ‘crunching of numbers’, taking into account all factors for both the company and individual(s) involved. 

As with a salary payment, a bonus is subject to income tax and National Insurance contributions (NIC) for the recipient and employers’ NIC for the company, subject to the £2,000 ‘employer’s allowance’ for 2014/15. Directors are taxed using an annual earnings period, such that the tax and NIC liability is calculated on an annual basis and any adjustment is made at the end of the year. What makes a difference is the timing of the bonus payment.

Dividends must be paid in proportion to shareholdings, which is not a problem with a one director company, but should there be more than one then the taking of a bonus must at least be considered for flexibility. Articles written previously in Business Tax Insider have discussed the tax benefits or otherwise of taking a dividend in comparison with the taking of salary (e.g. November 2013 ‘Dividends v Salary – What Is The Best Approach?’).

Although the paying of a dividend will often be a more effective method of withdrawing profits, if the company is loss making and has no retained profits, dividends will not be permitted; there are no such restrictions on the payment of salary or a bonus. Should a company find itself in the situation where a dividend is not possible then the declaring of a bonus will be the only way to withdraw monies, and in some cases could even result in a refund of tax for the company, out of which at least part of the bonus could be paid; see Example.

The amount of bonus that can be given is related to, and invariably depends upon, the company’s results for the previous year. Due to the way the tax rules work, it is possible to have a deduction for a bonus declared in a set of company accounts with the actual payment being made later. 

A bonus is tax deductible for the company in the accounting year to which the payment relates and not when the payment is actually made. A condition for the bonus to be tax deductible is that it must actually be paid within nine months of the year end of the accounts to which it relates. If the payment is related back to a year which already shows low profits, the taking of a bonus would reduce the profit even further resulting in a lower tax liability, or even create a loss with a tax refund. 

During the year to 31 March 2014 the company makes a profit of £10,000 before paying the director/shareholder. The company has a negative balance sheet. The director has not drawn a salary and he has other income against which his allowances are allocated. It is not possible to pay a dividend as there are no retained profits. The company pays the director a bonus of £40,000 in July 2014. On this amount employers’ NICs are chargeable of £4,457.95 ((£40,000 - £7,696) @ 13.8%) but with the £2,000 employer’s allowance this amount is reduced to £2,457.95. Employee’s NIC will be taken from the £40,000 payment. 

As the bonus is tax deductible for the company in the financial year in which it relates and not in the year in which it is paid, taking account of the bonus and employers’ NIC against the chargeable profit in the accounts for the year ended 31 March 2014 creates a loss of £32,458.

If the company had sufficient profits in the preceding 12 months to utilise the loss (i.e. the accounting year ended 31 March 2013), carrying the loss back would generate a tax repayment of £6,492 (20% of £32,458) out of which at least a proportion of the bonus can be paid.

A company involved in research and development claiming ‘R&D tax relief’ may also find that paying a bonus is preferable to a dividend. The claim will reduce the tax rate charged possibly creating a loss and if so, the loss can be exchanged for a cash payment, based on a percentage of the loss surrendered.

Under ’real time information’, the bonus payment will still be taxed in the same way as a salary payment, such that an ‘employer payment summary’ will be due and the tax thereon will be due on the 19th (or 22nd if paid by BACS) following the month of payment. 

With the introduction of penalty charges for late payment of PAYE/RTI, HMRC will obviously be keen to challenge the ‘nine months bonus’ practice mentioned earlier, should they be able to show that the bonus has actually been paid earlier. 

Using the ‘nine-month rule’ can provide the company with a useful cash flow advantage; the company benefiting from corporation tax relief (or even a refund), with the actual tax consequences for the director being deferred. 

A bonus provided for in the accounts but not paid within the nine months will only be allowable for tax purposes in the accounting period in which it is paid. 

To be tax deductible there must be a valid provision for payment shown in the accounts in which the bonus has been provided. Bonuses may only be accrued if there was a ‘legal or constructive obligation’ at the balance sheet date. This could be a constructive obligation on the grounds that bonuses are paid every year, but problems could arise should this obligation be used, as there might be a year where dividends are found to be the preferential form of payment. Therefore, the most prudent course of action is for there to be proper consideration prior to the year end, such that any obligation is properly documented; but this is not always possible. 

A valid provision must be confirmed by the passing of a board minute, thus providing evidence of the legal obligation to pay a bonus before the year end. If the calculation of the exact amount cannot be quantified then the board minute needs to state that that there is a liability to pay but that this cannot be established or quantified until the accounts have been finalised. The minute should be dated before the year end and include the basis for determination e.g. ’x% of profits’. A provision must also be made for the payment in the accounts.