Why you should maximize dividends when you can
Coronavirus has played havoc with dividends as a profit extraction method for owner managers of some companies and may have put them at a tax disadvantage for some time to come. How might a similar situation be avoided in future?
Profit extraction and tax efficiency
As a director shareholder of your company general tax advice to maximize tax and NI efficiency is to take a modest salary (up to the NI secondary threshold of £8,840 per year) and top it up with dividends. The trouble is dividends can only be paid by your company from its profits.
Trap. No profits means no dividends. Therefore, when your company is making losses and you rely on income from it you’ll either have to take more salary, which is costly in tax and NI contributions, or borrow from it. This can also be tax inefficient depending on how you repay the debt.
Maximizing dividends. In uncertain times like these it can be tax and NI efficient to take as much by way of dividends when profits allow even if you have no immediate need for the cash. The following two examples illustrate why.
Example – lower dividends. Ali and Moeen are directors and equal shareholders in Acom Ltd, a company they started in 2018. Its accumulated profit by the end of its 2019 financial year was £160,000. It paid dividends to Ali and Moeen of £110,000 (in addition to their salary). Acom’s business was then hit hard by coronavirus and in 2020 its remaining profit was eroded by losses. By the end of its 2020 financial year it had losses of £40,000. Ali and Moeen project Acom will not return to an overall profit until its 2022 financial year. Wile Acom has the money to pay dividends it’s prohibited from doing so because of the no-profits rule. The leaves tax-inefficient salary of borrowing as the alternatives for Ali and Moeen.
Example-maximized dividends. The circumstances for Acom, Ali and Moeen are the same as the previous example except that the company paid out all its £160,000 profit as dividends in early in 2019 and early 2020 before the financial hit from coronavirus. At the time Ali and Moeen didn’t need all the dividend income and so left the excess in Acom as a credit to their loan accounts. They could draw the money later without any tax or NI implications.
Tip. Taking income sooner rather than later meant Ali and Moeen could take more as tax and NI-efficient dividends compared to when they allowed losses to erode Acom’s profit. This reduced the tax and NI compared with taking salary even though they had to pay higher rate tax on some of the dividends.
If there’s uncertainty over the future profitability of your company it can be advantageous for it to pay out as much as it can as dividends. If you don’t need all the cash you can leave the excess in the company as a credit to your director’s loan account and draw it later without triggering any further tax or NI bills.