PAYE v Dividends – why tax efficiency shouldn’t always be the only consideration

It is not uncommon for shareholders of owner-managed businesses to be remunerated as a mixture of PAYE salary and top up dividends. This has been the case for many years as shareholders opt to draw their remuneration in the most tax efficient way.

What are the advantages?

There is one key advantage to be remunerated this way – save tax! Typically, an accountant will advise their client to maximise their annual personal allowance by drawing a basic salary through the company’s PAYE scheme. The personal allowance for the 2020/21 tax year is £12,500. In Layman’s terms this means that £12,500 can be drawn from the company tax free, but with a small deductions for those all-important national insurance contributions (NIC).

Any additional funds extracted from the company will ultimately be treated as dividends. Dividend income is currently taxed at 7.5% for basic-rate tax payers. When compared to the 20% income tax rates, that could be a huge saving. To give an example of how this works, see our illustration below. This compares a business owner being remunerated £60,000 by way of a salary, as compared to a mixture of PAYE and dividends:

Why every business owner shouldn’t be remunerated this way

As illustrated above, when this method of being remunerated works, it is great. It allows business owners to extract their hard earned cash with minimal tax liabilities. However, there are some disadvantages.

The Coronavirus Job Retention Scheme

The first disadvantage is one that thousands of small business owners are experiencing in the UK at present; those that have had no option but to furlough themselves. The Coronavirus Job Retention Scheme (or ‘furlough’ scheme) is typically based on an individual’s income through the PAYE scheme, similar to the statutory redundancy payment scheme. Using the illustration earlier, this means that the furloughed business owner who had a £60,000 salary will currently be receiving the maximum £2,500 per month. The director who opted to only receive a £12,500 salary, would only be entitled to reclaim £833 per month.

What about if the company becomes insolvent?

This is a question that is not always in the minds of directors who have formed a new company, but it should be. There are two fundamental issues with drawing remuneration by way of regular dividend payments:

1. Have the dividends actually been declared? and

2. Were there sufficient distributable reserves to declare the dividend?

On many occasions, the business owners will decide how much to draw from the business each month and then rely upon the expertise of their accountant at the year end to treat the remuneration correctly for tax purposes. From an accounting perspective this ordinarily creates an overdrawn director’s loan account as the year goes by, unless regular dividends are declared to clear the overdrawn loan account.

It is becoming increasingly common for directors to opt to place their company into a voluntary insolvency process, believing they have accounted for their remuneration correctly, only to then be asked to repay their overdrawn director’s loan account. It is only at this point will the directors ask the accountant to correct the position, but it will be too late. After all, a dividend cannot be retrospectively declared, especially when the subject company is insolvent. The reason for this is twofold. Firstly, the directors no longer have the power the declare the dividend (given that a director’s powers cease upon the appointment of an Insolvency Practitioner) and, secondly, the declaration of a dividend at a time where the directors undoubtedly know the company is insolvent is likely to lead to one or more actions against them by the Insolvency Practitioner pursuant to the various available provisions within insolvency legislation.

The solution to the above, is to make sure regular dividends are correctly declared and accounted for by the company. This means producing board minutes and dividend vouchers evidencing the declaration and, most importantly, management accounts to show that there are sufficient distributable reserves available.

Distributable Reserves

The term “distributable reserves” refers to Section 830 of the Companies Act 2006 which states:

(1)A company may only make a distribution out of profits available for the purpose.

(2)A company's profits available for distribution are its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made.

If the management accounts of the company reflect that there were insufficient accumulated reserves to declare the dividends, they are considered to be unlawful. In the ordinary course of business, future profits can be utilised to correct this position, but the same does not apply if a company becomes insolvent. If an Insolvency Practitioner discovers dividends were declared unlawfully, they will have to demand repayment from the shareholders and/or consider other actions against the directors for unlawfully declaring said dividends.

In conclusion, by all means be remunerated by way of dividends if it helps save tax, but always be conscious of the company’s solvency and that dividends have been adequately declared. If you are director of a company, or perhaps advising your clients who do have concerns regarding the solvency of their business and/or how they are being remunerated, please contact us for some FREE, no obligation advice. We are here to help.

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