Dividends and bonuses play a crucial role in tax planning for owner-managed companies. In the past, dividends had the upper hand in most situations, but recent changes have narrowed the gap between dividends and bonuses. With the main corporation tax rate increasing from 19% to 25%, the advantage of dividends is no longer guaranteed. This article examines the key differences between dividends and bonuses and offers guidance on determining the most tax-efficient option for your circumstances.
A dividend represents a distribution of a company’s assets, usually in the form of cash, to its shareholders. There are different types of dividends, such as interim and final dividends, each with varying tax implications. Interim dividends are proposed by the directors, while final dividends require approval from the company’s shareholders. The payment date for tax purposes differs depending on the type of dividend. To be valid, dividends must meet the requirements outlined in the Companies Act 2006, ensuring the availability of distributable profits. Failure to meet these requirements may result in an unlawful distribution, requiring repayment to the company. Dividends must be paid proportionally to shareholdings, meaning each shareholder receives a share based on their ownership percentage. While strategies like dividend waivers can manage this, they require careful consideration.
From a tax perspective, dividends are paid from a company’s after-tax profits and do not reduce its corporation tax liability. For individuals, dividends are subject to income tax at specific rates. There is a tax-free dividend allowance, which decreased from £2,000 to £1,000 for the 2023-24 tax year. The income tax rates on dividends are 8.75% for the basic rate, 33.75% for the higher rate, and 39.35% for the additional rate. Individuals pay the tax due through self-assessment, with the full payment usually due on January 31, 2025, unless payments on account are required.
It’s important to note that dividends are not considered earnings. This has implications, such as the absence of National Insurance Contributions (NICs) on dividends and their exclusion from calculations for tax-relievable pension contributions.
Bonuses are one-time payments made to recognize exceptional company or individual performance. They differ from salaries, which represent regular compensation according to employment contracts. Bonuses are treated as earnings and are subject to income tax and NICs. The income tax rates depend on the individual’s residency, with different rates for Scotland compared to England, Wales, and Northern Ireland. In England, Wales, and Northern Ireland, the income tax rates are 20% for the basic rate, 40% for the higher rate, and 45% for the additional rate. NICs are payable by both the individual and the company, with rates varying based on earnings thresholds.
The company is entitled to corporation tax relief for bonuses and the NICs it pays. This relief can reduce the company’s corporation tax liability, especially if its profits fall within the marginal relief band. However, the wholly and exclusively rule applies, and relief is granted on a paid basis if the bonus is paid more than nine months after the end of the company’s accounting period.
Determining Tax Efficiency
The choice between dividends and bonuses depends on individual circumstances and requires careful consideration of the numbers. To assess tax efficiency, it can be helpful to compare the after-tax receipt for the individual while keeping the company’s cost the same. For example, if a company has profits of £500,000 for the year and £40,000 available for distribution, comparing the after-tax receipt under the bonus and dividend routes can indicate the more favorable option.
In the provided example, choosing the bonus route results in a higher after-tax receipt for the individual (£20,386) compared to the dividend route (£20,213). However, it’s essential to note that the tax advantages may change based on tax rates and allowances. In the previous tax year, the dividend route offered a higher after-tax receipt, demonstrating how recent changes can impact the outcome.
Choosing between dividends and bonuses involves considering various tax and non-tax factors. While dividends have traditionally provided greater tax savings, recent changes to tax rates and allowances have diminished or even eliminated this advantage. Consequently, the bonus route may yield better results for certain taxpayers. To make an informed decision, it is crucial to carefully evaluate all relevant factors. Reach out Seagrave French to get best tax advise applicable to your financials.