How to Avoid Illegal Dividends

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Director Remuneration in 2020/21

Much has changed and how Directors remunerate themselves during 2020/21 tax year is no longer a simple question of tax efficiency.  

In this article I’m going to quickly recap why we operate a Salary/Dividend blend, the benefits and the unexpected problems we may face with this form of remuneration in 2020/21.   I’ll try and keep this brief and straight forward so the actual calculations used will be for example purposes and will not be detailed enough to cover every situation.

The aim is to make you aware of the potential pitfalls so that you are in a position to make a pro-active decision rather than find out later, and much to your cost, that you should have been on a different course. 

Let’s start with the basics. 

As Company Directors we are able to pay ourselves a blend of Salary and Dividends to reduce our overall tax burden.  We typically pay a small salary, on which we receive a full corporation tax deduction, and top up with a regular dividend payment.  The salary element normally attracts zero income tax and our dividends, at least in the lower rate band are taxed at just 7.5%. 

This sounds amazing but the funds from which dividends are paid are “post tax profits” which means we have effectively already paid 19% corporation tax on those earnings prior to recording a dividend. 

Do you have Profits or Reserves?

I suspect many small businesses will have at best greatly reduced profits this coming year and possibly be loss making.   If you don’t have any profits or any brought forward reserves your drawings can’t be treated as Dividends.

If you withdraw funds from your company, which aren’t recorded as Salary, that exceed post tax profits and brought forward reserves then it’s deemed a “Directors Loan” and you are liable for a 32.5% special rate of corporation tax.  The special rate of corporation tax is equal to the higher rate tax on dividends and applied to any overdrawn Directors loan balance as at the end of your company’s financial period.

Added to this the loan is a taxable benefit on which both you and the company will pay an element of further tax.

Wait it gets worse!

Should your company fail and go into administration whilst you have an overdrawn directors loan account you, as an individual, become a “debtor” to your company and the administrator will pursue you personally for repayment of the debt.  Your personal wealth and assets are at risk in this scenario. 

Warning signals.

If trade and profits have fallen but you are continuing to withdraw a dividend then check that your company is either generating enough post tax profit to cover the dividend or that you have enough brought forward reserves.  

Just because you have enough profits/reserves in the first quarter does not mean you will by the end of the year.   For example, let us assume your company is making £5k per month in post-tax profits for the first 6mths of the year and you draw a £30k in dividends during that time.  Then business take a turn for the worse and you make a £5k loss for the next six months.   Total trading profits for the year in this example would be “0” but you have already taken a £30k dividend which will result in an overdrawn director’s loan account and a 32.5% CT charge.  Worse still if your company then goes into administration and you are asked to personally repay the £30k loan.

Final notes: dividends can only be paid out of post-tax profits or reserves.  Just because you have cash in the company account does not mean you can draw a dividend.  The cash may be for payment of future liabilities such as VAT, Corporation Tax or it may be a result of taking out a bounce back loan.   You cannot use loaned money to pay a dividend.   

During this period its essential you keep good accounting records and monthly management accounts to help you track your profit.  If you carry on blindly taking a dividend you may end up in a much bigger mess than if you had switched to salary despite the additional tax burden that would bring. 

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