The dividend versus bonus debate
QUESTION: I've decided to pay my employees and shareholders a January bonus or a dividend as a thank you for all their hard work in 2018. Given the tax advantages of dividend payments I'm wondering whether I should be considering bonuses at all or whether I should just pay everyone a dividend? Are there any pitfalls in paying dividends instead of bonuses?
ANSWER: The dividend versus bonus debate is not always straight forward. For many years the dice has been loaded in favour of dividend payments, but you may want to consider the following factors before you decide which method of payment to make to your shareholders and staff.
There are many occasions when a dividend payment is not only less tax efficient than a bonus, but also unlawful. At the outset it is important to remember that dividends can only be paid to shareholders. A salaried employee, even if registered as a company director, is not entitled to dividends unless he or she is also the registered holder of company shares. If a company has more than one class of shares extra care is required, particularly if each class of share carries different dividend rights.
It is important to remember that once a dividend has been declared it must be paid to all the shareholders in proportion to their percentage shareholding. If shareholder A owns 10 per cent of the company shares and another family member, shareholder B, owns 90 per cent of the company shares it is not possible to declare a £10,000 dividend to shareholder A and not also make a £90,000 dividend payment to shareholder B. Often, shareholders try to circumvent these rules by using ‘dividend waivers' which involves one or more shareholders waiving all or part of their entitlement to a dividend.
There is, however, much case law and anti-avoidance legislation associated with this type of tax planning and extra caution is recommended to avoid HMRC challenge. Another method of tax planning to avoid the requirement to pay a dividend to all shareholders is the use of what is commonly termed ‘Alphabet Shares'. Again, this type of tax planning, if put in place correctly, can provide an effective method of facilitating and simplifying varied dividend payouts. This is complex planning however and advice should be sought before changing existing share structures.
From a legal perspective it is necessary for a company to have sufficient 'distributable reserves' from which to make a dividend payment. Distributable reserves are typically the cumulative post tax profits of a company, less any dividends paid out during the life of the company. It is illegal under company law to pay a dividend if there are not sufficient distributable profits; this is a very important point to understand.The difference between cash held by a company and the distributable profits figure is an important distinction to grasp. If a dividend is found to be unlawful the recipient may be deemed to have received a loan from the company and this could have adverse tax implications as the loan may be taxed as a benefit in kind. In comparison with the administrative simplicity associated with bonus payments, it is necessary to follow procedures for voting and documenting dividend payments. If the required paperwork is not completed correctly a payment to shareholders may not be treated, or taxed, as a dividend under company law, resulting in unexpected additional tax charges.
Finally, dividends are not treated as ‘earnings' for tax purposes. This may have an impact on the level of pension contributions that an individual can make. If an individual's salary is reduced to a low level and topped up or substituted by a dividend this can also affect the individual's state pension entitlement. Very importantly from a company's perspective, dividends do not count toward the national minimum wage and dividends are not treated as qualifying expenditure for some very valuable corporation tax reliefs such as Research & Development tax relief.
Despite the possible hurdles and difficulties associated with dividend payments it remains the case that generally dividends are more tax efficient that bonuses. Nevertheless, all company owners should regularly review how best to structure one off payments to staff and employees to ensure those payments are lawful and tax-efficient.
:: Janette Burns (email@example.com) is associate tax director at PKF-FPM Accountants (www.pkffpm.com). The advice in this column is specific to the facts surrounding the question posed. Neither The Irish News nor the contributors accept any liability for any direct or indirect loss arising from any reliance placed on replies.