Using Bonuses To Reduce Business Tax

 

Most readers will be familiar with the idea that paying a salary to your spouse (or other family members) can be very tax-efficient if:

1. they are not otherwise fully utilising their tax-free allowance/lower tax bands; and
2. they do real work to justify the salary, otherwise HM Revenue and Customs will try to disallow the business expenditure.

In an ideal world, the business gets tax relief and the spouse receives income with relatively little tax cost. The idea of paying bonuses is similar. Company directors may decide to pay themselves a bonus and one consequence should be to reduce the company’s taxable profits, and the tax it then has to pay. There may be further PAYE income tax and National Insurance contributions (NICs) on the bonus to pay later on, but that will depend on the circumstances in the tax year of payment. Generally, I would consider bonus arrangements as a deferral mechanism. 

 

Let’s take Jumbo Limited, which has a July year end. The company is already doing very well in the year to July 2016, and the four directors are concerned about the potential corporation tax bill. Mr Jumbo Snr. has heard that providing for a bonus will reduce the corporation tax bill.

 

If they pay the bonus immediately, the increase in the company’s PAYE and NICs bill will probably exceed any corporation tax saved – and may be payable sooner than the corporation tax. 

 

So Mr Jumbo Snr. decides that, at the next board meeting, he will propose that the directors are each paid a bonus of £25,000 sometime after the year end, but they will include a provision for the deduction in the company’s July 2016 accounts, because the bonus was earned for the excellent 2016 results. This ‘accrued expense’ in the company’s accounts should reduce the company’s taxable profits for the July 2016 accounting period but – so far – nobody has had to suffer any PAYE or NICs because nobody has been paid (but see later, as this story is not over).

 

In theory, you can defer a bonus payment up to nine months – which could easily be into the following tax year. This is allowed by the legislation (CTA 2009, s 1288), which effectively requires that, if the payment is made more than nine months after the end of the accounts, then a corresponding tax deduction is not allowed for the original accounts but instead in the period in which it is actually paid (the equivalent legislation for other businesses is at ITTOIA 2005, s 36).

 

For example, in the case of Jumbo Limited above, this means that a deferred bonus adjustment in the July 2016 accounts will remain tax-allowable, so long as the bonuses are actually paid no later than the end of April 2017.

 

The rules derive from the PAYE legislation (thanks to CTA 2009, s 1289(4), and ITTOIA 2005, s 37(4)).

 

For ordinary employees, the rules are quite simple. It is the earlier of:

• when a payment of earnings (or an account of earnings) is made; or
• when an employee becomes entitled to be paid’

Directors, however, are a special case; for them, it is the earliest of:

1. when a payment of earnings (or an account of earnings) is made;
2. when an employee becomes entitled to be paid;
3. the date when earnings are credited in the company’s accounts or records;
4. where the amount of earnings is determined before the end of the period to which they relate, the date that period ends;
5. where the amount of earnings is determined after the end of the period to which they relate, the date the amount is determined.

In Jumbo Limited, Mr Jumbo Snr. is suggesting that the bonuses will be paid some time after the end of the accounting year – 31 July 2016. So they haven’t physically been paid yet. Nor is anyone entitled to be paid yet, essentially because the date of payment has not yet been fixed. Nor has anyone moved a muscle to update the company’s books and records. 

 

But Mr Jumbo Snr. has specified how much he intends each of the four directors will be paid - £25,000. So if the directors ultimately agree to take £25,000 each, the PAYE/NIC liability will crystallise on 31 July 2016, in line with point (4) above. That would be much earlier than would be ideal.

 

There is a risk of getting bogged down in some very fine detail here around the correct application of accounting standards (and not all businesses have to use the same standard) but, very simply, accounting standards permit a provision or accrual in a set of accounts when:

• there is an effective obligation to pay something at the end of the accounting period; and
• the amount can be reliably estimated.

At this stage, Mr Jumbo Snr. is getting a little perplexed:

‘We have to agree before the year-end that a bonus will be paid at some point, otherwise we cannot include a deduction in the accounts but that means we have to account for PAYE, etc., at the year-end. Also, we have to know the amounts before we can make a deduction in the accounts, but if we fix the amounts, then PAYE will be triggered!’

 

While bonuses can seem a bit ‘catch 22’, they can work. Let’s say that Mr Jumbo Snr. proposes the following at the next board meeting:

• the company is doing very well in the year to July 2016, and he thinks that the directors should take a bonus; and
• the bonus pool will be £100,000, but who gets exactly how much of the £100,000 will depend on factors that will only be calculated when (say) the annual accounts are drawn up – at some point after the end of the year. 

If this approach is agreed by the board (by the end of July 2016), then 

• the company will have an effective commitment to pay out £100,000 in bonuses. This commitment will exist at the year-end, so it will be OK to include it in the accounts, on that test;
• likewise, the amount can be ‘estimated’ reasonably accurately, at £100,000, so again, it is OK to include the provision in the accounts; 
• however, it is not yet possible to determine how much bonus will be paid to whom. Only when the accounts are drafted will each director’s precise entitlement be worked out. So the amount for PAYE purposes will not be ‘determined’ by the end of the year in point (4) above, but at some later date when the accounts are drawn up – i.e., point (5), after the end of the accounts year.

Deferred bonuses can work to reduce a business tax bill, but care is needed to ensure that the accounting deduction is valid for tax purposes – without triggering a PAYE bill earlier than intended.

 

There are several ways to ‘get it right’, such as using a formula or performance conditions based on the final results so that the provision can be estimated sufficiently well, but the precise amount is not fixed (so a PAYE bill is not triggered early). 

 

If you have a formula or similar in mind, check with your accountant that your proposed approach will work before committing.

 

Justifiable bonuses to family members who are not directors (and who have spare tax-free personal allowances and/or lower tax bands) are most tax-efficient and easiest to plan. 

 

These rules apply for ordinary businesses, not just limited companies – but remember that a self-employed person or partner cannot defer a bonus to himself because he’s taxed on profits not drawings (although spouses, etc., can be employees).

 

Don’t forget to accrue for employers’ NICs on the bonus in the accounts, which will improve the tax saving/deferral.