If you trade through a limited company, it is fairly likely that you will need to take money out of the company for your own personal use.  However, the methods for doing this can be confusing, and is almost always discussed when I have meetings with directors of new limited companies.

In addition to salaries, the two main options for taking money out of a limited company are dividends and loans, which are broadly defined as follows:

• Loans are monies taken from the company for personal use, often on a regular basis.
• Dividends are declared by the directors of the company to reward shareholders, and must have paperwork to support.  However, they can only be declared from ‘retained reserves’.

The term ‘retained reserves’ means accumulated post tax profits.  In other words, profits after tax.  If, for example, ABC Limited makes a pre tax profit of £30,000 in its first year, then 20%, or £6,000, corporation tax needs taking off which leaves post tax profits of £24,000.  This effectively means that ABC Limited can declare a dividend of £24,000.

However, the director of ABC Limited may need £2,000 on a monthly basis to pay his personal household expenditure.  He may not be able to wait until the end of the year to declare dividends.  So what can he do?  He has a couple of options:

• Declare a dividend of £2,000 each month.  The downside with this approach is showing that the company made a profit of £2,000 each month to support the dividend.  Profits often fluctuate from month to month.
• Take a loan of £2,000 each month from the company, which will be posted to the directors loan account.  The amount owed to the company will then build up, and can be cleared by declaring a dividend on a periodic basis, such as quarterly, bi-annually or annually.

You may realise that there’s a certain amount of risk with the second approach, as there is no guarantee that the company will make the profits to declare a dividend to clear the loan off.  Therefore, it is very important that loans are kept to a minimum, particularly in the first year.  It is essential that money is retained within the company for the corporation tax bill (which should be 20% of taxable profits).  The consequences of having an overdrawn directors loan account can be quite serious, so care needs to be taken to get it right.

We manage dividends for the majority of our limited company clients, even putting the paperwork together.  If this is a service you wish to discuss, please do not hesitate to get in touch.

The Summer Budget included an announcement a new dividend tax, effectively changing the way that dividend income is taxed.

The Current System

Dividend income is paid from post tax profits (also known as retained reserves). At the moment, there is no extra tax to pay on dividends if you are a basic rate taxpayer (i.e. 20%).  If you are a higher rate taxpayer, then you will have to pay income tax of 25% of the net dividend.

Example 1: if you have a salary of £10,000 and receive dividend income of £20,000, you will have no personal tax to pay. (**)

Example 2: if you have a salary of £10,000 and receive dividend income of £40,000, you will have a personal tax bill of £1,904 (which is on the portion of the dividend over the higher rate tax threshold of £42,385).

The Proposed System

The announcement in the Summer Budget suggests that dividend income is going to be overhauled.  Everyone will have an annual allowance in respect of dividend income of £5,000.  A dividend tax will be applied to any dividend income over £5,000.  The tax will be 7.5% in the basic rate band, 32.5% in the higher rate band, and 38.1% in the additional rate band.

Example 3: if you have a salary of £10,000 and receive dividend income of £20,000, you will have a personal tax bill of approx.. £1,125.

Example 4: if you have a salary of £10,000 and receive dividend income of £40,000, you will have a personal tax bill of £4,529.

As you can see, it is likely that the tax bill of the dividend recipient will increase from the start of the 2016/17 tax year.

Does This Affect You?

If you receive dividend income from quoted companies, then unless you have a large shareholding, it is likely than you won’t be affected, as you have a £5,000 allowance. However, if you are a shareholder in a small limited company and receive dividend income, then it will probably affect you. The difference between examples 1 and 3 shows that if you have £30,000 income and you trade through a limited company, you will be out of pocket.

What Can You Do?

First of all, don’t panic or do anything rashly. The announcement has still got to go through parliament, and it is possible that the end result may differ. Also, the fine details are still being released. The changes are expected to start from 6 April 2016, so there is plenty of time to consider alternative strategies, such as different levels of remuneration, transferring shares, or even disincorporating.

However, as things stand, there is a window up until 6 April 2016, and our initial advice is to maximise dividend income up to that point, without doing anything detrimental like straying into higher rate tax territory.

As advisers, we are more than aware that this will have significant changes for our clients, and will be monitoring the situation closely over the next 8 months. We also hope to contact all clients who are affected directly. If, however, you wish to know more or have a chat to discuss the options, please do not hesitate to contact us.

(** Example assumptions - £10,000 personal allowance threshold, higher rate threshold £42,385)

A common way for directors to be remunerated from small limited companies is to take a combination of salary and dividends.  However, there are ramifications if the company gets into trouble.

In the case of an insolvency, liquidators and administrators will seek to recover all assets for the benefit of the creditors.  The issue of unlawful dividends arises in cases where small business owners take remuneration by way of dividends rather than salary, specifically more dividend than they are entitled to.  Where an Insolvency Practitioner identifies that a dividend is unlawful he will ask the shareholder to repay it or an equivalent value (if the distribution was of a non-cash asset).

Directors and shareholders should be aware that specific steps and criteria must be met and complied with before declaration and payment of dividends.  Failure to comply with the complex provisions of the Companies Act 2006, the company’s own articles of association and a director’s general duty of care can result in dividends being declared unlawful.  The key points to bear in mind are as follows:

• Ensure that the Company has sufficient retained reserves (aka available profits) to pay a dividend. If directors rely on the company’s most recent annual accounts, they must demonstrate that they have taken due consideration of post balance sheet events to be able to declare a dividend.
• Interim accounts should be sufficient for directors to make a reasonable judgement on a proposed dividend and should include profits, losses, assets, liabilities, provisions, share capital and reserves.
• In considering a distribution, directors must be mindful of their fiduciary duty to safeguard the company’s assets and be in a position to demonstrate that they have exercised reasonable care, skill and diligence in ensuring that the company is able to settle its debts as and when they fall due.
• Hold a meeting of the members to authorise the declaration of a dividend and its payment, ensuring that the meeting correctly recorded.

These key points are touched on here.

The consequences of unlawful dividends are considerable for directors and shareholders.  Shareholders may be asked to repay dividends, and could find that HMRC will re-categorise the income as salary (which will be subject to extra income tax and NIC).  Directors could find themselves in breach of their duties and therefore held to be personally liable.

In difficult or challenging trading circumstances, directors should look very carefully at whether they should continue to withdraw funds from a company by dividend.  Reasonable remuneration paid through the PAYE system is unlikely to be queried by an Insolvency Practitioner – although if the company isn’t trading profitably, then it is unlikely that money will be available to draw as either salary or dividend.

As accountants, we advocate the responsible administration of dividends and look to help our clients in achieving this.  If you need any help, please contact us.