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What if you change a dividend to salary

Stress business woman

Let’s look at the case of Richard and Julie Jones v HMRC [2014] UKFTT 1082 (5 December 2014).

They took a small salary and regular dividends from their recruitment company which was absolutely fine until the company got into financial trouble!

Their accountant (unethically but in an attempt to help their client) suggested they should re-write history and change the dividends to salary so that the liquidator couldn’t recall the dividends.

HMRC then decided to demand PAYE and NI and pursued Richard and Julie personally.

HMRC was refused the right to collect PAYE tax and NI due on the salary, not because the law didn’t allow it, but because it wasn’t possible for Richard & Julie to reclassify the dividends. They had been properly paid and the correct procedure followed. History couldn’t be rewritten and the dividends should have been changed to loans if the dividends were illegal.

steve@bicknells.net

Interim or final dividend – does it matter which?

Image

Dividends are used by many business owners as a tax-efficient way to extract profit from a company. So it is important to understand the procedure for paying them. But does it matter whether the dividend is final or interim if the tax treatment is the same?

The Companies Act 2006

It isn’t HMRC that makes the distinction between the two dividend types, but company law. The Companies Act 2006 says “The company may by ordinary resolution declare dividends, and the directors may decide to pay interim dividends”

So one group of  people, the directors,  may pay interim dividends, but shareholder approval must be obtained before a final dividend is paid.

So why is HMRC interested?

HMRC doesn’t particularly care which type of dividend is paid. It is interested in whether the payment is really a dividend or whether it was salary a bonus or a loan payment. As higher taxes and NI may accrue with these payments HMRC will want to see proof that the payment was a genuine dividend.

And this is where the timing of the payment and the paperwork are important. Under new anti-avoidance rules it is no longer possible for a director to receive a loan from the company, repay it to avoid the 25% tax charge and then take out a fresh loan within 30 days. HMRC will want to be certain that the payment is indeed a dividend. If the correct procedure has been followed and the paperwork is complete then this should not be challenged.

Why have multiple classes of shares?

Successful Businessman With A Contract In Hand

Businesses tend to start off just having ordinary shares with full voting and dividend rights, however, there are lots of good reasons why you might create multiple share classes:

 

1. To reward the owners based on their contribution – for example say one owner worked full time and the other only part time – they may want dividends to be based on their efforts whilst still retaining their original voting rights

 

2. To offer non voting shares to employees

 

3. Convertable or Redeemable shares might be offered to an investor

 

4. Preference Shares might have a fixed dividend

 

Dividends are very tax efficient so its great way to reward the owners for the risk of running a business.

 

Always seek professional advice before making changes to check for capital gains, settlement and other tax and legal issues, better safe than sorry.

Then before creating additional share classes check your articles of association and change them if necessary, then you will need a resolution to create new share classes, fill the appropriate forms at Companies House and then you are ready to go.

 

 

steve@bicknells.net

… should I ‘go limited’?

This is a question I am asked often, normally in casual conversation at social gatherings, and one of the reasons I try not to let people know that I’m an accountant; I can only imagine how much worse it must be for doctors …..

Without knowing precise details of a business operation, it is difficult to respond to such questions with any great certainty, but there are some ‘rules of thumb’ we can employ to which might lead us to a reasonable conclusion.

But first, it might be worth taking a brief look at what options exist and what the main features of each are, and in doing so I am deliberately excluding Public Limited Companies (“plc”) which is the legal form of a majority of large businesses which shares are traded on various stock exchanges.

Private Limited Liability Company (“Limited”)

A limited company is formed, or ‘incorporated’, by an individual or group of individuals wishing to carry out a particular business. Most importantly, once incorporated, the company is a separate legal ‘person’ from its owner(s); it exists in its own right, pays its own taxes, can sue or be sued, and so on.

A Memorandum of Association is drawn up which states why the company has been incorporated and what business it is allowed to undertake, and Articles of Association set out the basic rules by which the company should be run, such as what happens when one of the owners wishes to sell their share of the company.

The owner(s), often referred to as ‘members’, will each own a share of the company (hence the alternative term ‘shareholder’), their liabilities for the debts of the company are generally limited to whatever they have paid for that share of the company, and their personal assets are therefore protected from attack by creditors of the company.

The owner(s) will appoint one or more ‘directors’ to run the company for them (i.e. to ‘act for the company’ so that it effectively operates through them). The directors may be paid a fee and/ or expenses for attending meetings and generally acting for the company.

In turn the director(s) may employ staff to work within the company and may themselves work within the company, and this is often referred to as an ‘executive’ directorship, as distinct from a ‘non-executive’ directorship where the director may attend board meetings only and vote on various issues concerning the running of the company.

In law, executive and non-executive directors are all simply directors and have the same authority and responsibilities for the running of the company, but executive directors will have additional authority and responsibilities in terms of running the business of the company as set out in their service contract or contract of employment, and for which they will normally be paid a wage or salary.

So an individual may be a shareholder, and/ or a director, and/ or an employee (executive) of the company, but they are three very distinct roles and whenever an individual acts ‘on behalf’ of the company, or the company’s business, he or she needs to be clear which ‘hat’ they are wearing so that these roles do not become confused.

This distinction is particularly important when considering payments made between the company, its director(s), its owner(s), and its employee(s) so for clarity:

The company itself (not the owners), is liable for ‘Corporation Tax’ on the profits it makes and currently there is a Small Companies Rate of 20% on profits of up to £300,000 in a year, and thereafter a Main rate of Corporation Tax of 23%, but these change periodically so please check the current rates at http://www.hmrc.gov.uk/rates/corp.htm.

The company pays its employee(s) for the work they do and such payments are legitimate business costs and can be set against profits thereby reducing any corporation tax due; conversely these payments are income for the employee(s) on which they will need to pay tax and other deductions (the company is required by law to act as tax collector on behalf of HM Revenue and Customs making deductions at source under “Pay As You Earn”).

Any profits made by the company, after corporation tax has been paid, can be shared out between the owner(s), normally pro-rata to their shareholding, and this is termed a ‘dividend’ payment, and because corporation tax has already been paid in respect of these profits, the dividend carries a tax credit (currently 10%) which the owner(s) can effectively claim back as tax already paid against any other tax they may need to pay.

Tax on such dividend income is at a lower rate to normal earned income (I don’t know why but have always presumed in recognition of the risk the owner(s) have taken in investing in their company), and so currently if the owner is a basic rate taxpayer, the tax credit fully offsets the tax due on the dividend income, and so there is no further tax to pay on it; again these rates change from time-to-time so please check the current rates at http://www.hmrc.gov.uk/rates/it.htm.

One particular downside of tax regime as applied to limited companies to be aware of is that where the company provides a car for its employees, whether executive directors or other staff, this is deemed to be in lieu of wages or salary, and regardless of whether the car is a necessary tool of the trade as it is for many small business owner/ directors, or individuals with for example sales roles. And depending upon the cost of the particular car and whether the company also provides fuel, the tax assessment can be quite harsh – see http://www.hmrc.gov.uk/calcs/cars.htm. This tax regime also applies to commercial vehicles provided by the company though the tax assessment is currently less harsh.

Finally, a company is required to disclose details of its operation including a ‘filing’ of its annual accounts at Companies House where other individuals and organisations can view these. For many small businesses this will be an abbreviated version of what is prepared and submitted to HM Revenue and Customs being limited to an end of year balance sheet only, rather than the full profit and loss account required by HMRC.

Sole Trader

When an individual ‘starts up in business for themselves’ then they are termed a ‘sole trader’, and unlike the limited company, which is a separate legal entity from its owner(s), the sole trader and his or her business are one and the same.

The most important consequence of this is that generally, all the personal assets of the sole trader are at risk from attack by creditors should the business fail or find itself in difficulty.

The main advantages of this trading form is its simplicity and the lack of disclosure of the businesses financial affairs at Companies House (there is little real saving in record keeping or accounts preparation since the accounts to be prepared each year for HMRC are little different to those required for a limited company).

The sole trader is liable for tax and national insurance on the profits made by their business and any salary or wage which they take out of the business is not allowable against these profits in calculation the tax and NI due.

Conversely such payments, which are termed ‘drawings’, are essentially a distribution of the profits made and are not assessable for tax since they have already been taxed originally as profits. Note that monies introduced into the business by the sole trader are termed ‘capital introduced’, profits made add to this capital, and drawings (including tax paid) taken reduce it, so if the business is not making profits then any drawings simply deplete the capital (and cash reserves) of the business

Further, there is no saving in payroll administration once the sole trader takes on staff since as with a company the sole trader pays its employee(s) for the work they do and whilst such payments are legitimate business costs thereby reducing any tax due from the owner in respect of his/ her business profits, these payments are of course, income for the employee(s) on which they will need to pay tax and other deductions (the sole trader is required by law to act as tax collector on behalf of HM Revenue and Customs making deductions at source under “Pay As You Earn”).

Equally, whereas the sole trader can generally charge the business proportion of all running costs of a vehicle to profits, thus reducing their tax bill, any vehicle provided to employees fall under the same regulations as those for company employees.

The sole trader will generally have to make advance payments of tax, essentially a deposit or ‘on account’ payment on the current year’s anticipated profits, and which will be estimated based on the previous year’s profit, so there is a real danger in a poor trading year of substantially overpaying tax when cashflow can least afford it, albeit the overpayment can be refunded once the true trading position becomes clear.

Finally, consideration should be given to timing when starting up the business in relation to the tax year since HMRC will assess profits made by ‘basis period’ – see http://www.hmrc.gov.uk/manuals/bimmanual/BIM71010.htm which may mean that any profit may be the basis for assessment of tax in more than one tax year.

Partnership

There are several types of partnership but generally what is referred to when speaking of ‘a partnership’ is a Partnership within the meaning of the Partnership Act 1890 – see http://www.legislation.gov.uk/ukpga/Vict/53-54/39/contents

Such partnerships are formed by two or more individuals wishing to carry out a particular business, and they may or may not formally write down any rules and regulations for running the partnership such as who will receive what share of any profits.

If such partnerships are thought of as a ‘group of sole traders’, then much of what is set out in the above section can be said to apply equally here. However there are two variations on this basic theme:

Limited Partnership regulated by the Limited Partnership Act 1907 see – http://www.legislation.gov.uk/ukpga/Edw7/7/24/contents – in which at least one of the partners restricts their liability for the debts and obligations of the firm to a pre-determined sum, instead of bearing unlimited liability as a partner normally does.

The partnership must consist of at least one general partner who manages the business and bears unlimited liability to creditors, and at least one limited partner (who may not take part in the management of the firm’s business). The limited partner must contribute a specified amount of capital on joining the firm, which they cannot withdraw as long as they remain a limited partner, but cannot be made to bear any liability to creditors or their fellow partner(s) in excess of that amount plus any undrawn profits.

A limited partnership must register with the Registrar of Limited Partnerships in London or Edinburgh as appropriate and failure to register deprives it of its limited liability status.

Limited Liability Partnership (“LLP”) – governed by the Limited Liability Partnership Act 2000 – see http://www.legislation.gov.uk/ukpga/2000/12/contents – an alternative corporate business vehicle that gives the benefits of limited liability but allows its members the flexibility of organising their internal structure as a traditional partnership.

It is a separate legal entity and, while the LLP itself will be liable for the full extent of its assets, the liability of the partners will be limited.

Any new or existing firm of two or more persons can incorporate as an LLP, which must be registered at Companies House and for which the registration process and cost of registration are similar to that for a limited company.

Disclosure requirements are also similar to those of a company since LLPs are required to provide financial information equivalent to that of companies, including the filing of annual accounts, an annual return, and notification of any changes to the LLP’s membership, members names & residential addresses, and change to their Registered Office Address.

However, a LLP is taxed as a partnership, the partners providing capital and sharing any profits (the LLP will normally be regarded as transparent for tax purposes and each member will be assessed to tax on their share of the LLP’s income or gains as if they were partners of a general partnership governed by the Partnership Act 1890; partners will be liable to pay Class 2 and Class 4 NIC.

Summary

The trading form of the business, as we can see from the above, can take a variety of forms, and in answer to the question originally posed it is useful to consider the response to the following points:

1. if the business is relatively simple with little by way of borrowings from banks and other lenders, or credit to customers, or from suppliers, then a simple sole trader (or partnership for more than one individual) may be most appropriate;

2. where protection of personal assets and therefore limited liability is an important consideration then incorporation as a private limited liability company (or change to LLP status for an existing partnership) should be seriously considered (but be aware that this will still not protect the owner/ director if personal guarantees have been given to lenders in lieu of security for their loan);

3. if the business runs expensive motor cars then there could be a significant additional tax liability arising on incorporation of the business which might outweigh other advantages (if limited liability is desired then it may be worthwhile considering removing the vehicles from the business and running as privately owned vehicles, and charging the company per mile for use on company business post incorporation);

4. there is some flexibility on when and how much tax is paid overall for a limited liability company, for example, profits and therefore cash could be retained in the company, say for investment, and distributed subsequently as dividends when cashflow permits (as a sole trader or partnership there is less flexibility in that tax is due on profits irrespective of whether cashflow has permitted the profits to have been taken as drawings) so if such flexibility is important then again incorporation should be considered;

5. save for at business start up, tax is normally paid earlier by sole traders and partners, so there may be cashflow advantages in incorporating once the business has been established.

The above is of course, a very generalised assessment and having given due consideration to these generalities, I would advise that you then talk over the particular requirements of your particular business with your accountant and/ or business adviser before making a final decision.

As ever in life, few alternatives are ‘all good’ or ‘all bad’, and you will need to weight up the pros and cons as they apply to your particular circumstances and settle on the best overall option for you.

Paul Driscoll is a Chartered Management Accountant, a director of Central Accounting Limited, Cura Business Consulting Limited, Hudman Limited, and AJ Tensile Fabrications Limited, and is a board level adviser to a variety of other businesses.

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