Generally speaking, the payment of dividends on shares is the most tax-efficient way to extract the profits from a family company. This is not always the case, but if your family company pays significant salaries to its shareholder/directors, and does not pay dividends, then you should have a word with your tax adviser to make sure you are not paying more tax than you need.
Having pointed out the benefits of dividends, I have to say that they seem to cause a lot of problems for family companies. Mistakes, sometimes costly ones, are surprisingly common, and this article will highlight some of the most frequent errors and how to avoid them.
A company can only pay dividends out of its “distributable profits”. These are the company’s profits after it has paid its corporation tax. Any such profits not paid out as dividends will be carried forward to the next year – and any losses will have the effect of reducing the distributable profits available for the payment of dividends.
It is essential that the directors of the company are confident that the company has sufficient distributable profits to cover any dividend they intend to pay. How they do this depends on what sort of dividend is involved:
A final dividend is one that is “declared” by being included in the company’s accounts at the end of the year, and normally there are fewer problems with these, because the draft accounts will show clearly whether the company has enough distributable profits to pay the proposed dividend – and the accountant who prepared the company’s accounts will be able to advise on this. Final dividends are “declared” by the shareholders voting to approve the company accounts at the Annual General Meeting, and are typically paid a few days later.
Many companies also pay interim dividends during the year, and it is these that can cause problems. The directors (whose responsibility it is to pay interim dividends) must be satisfied that the company has sufficient distributable profits at the time the dividend is paid – so, for example, if the company’s last annual accounts showed distributable profits of £50,000, but since then the company has been making losses, those losses must be deducted from the £50,000 to arrive at the profits now available for distribution. It follows that the directors need to have up to date management accounts available to them in order to decide if an interim dividend can be paid.
“Ultra vires” dividends and loans to shareholders
If a family company pays dividends that are greater than its distributable profits, the overpaid amount of the dividend is an “ultra vires” payment (that is, a payment the company had no power to make). In the case of such a company, this has several consequences:
- The shareholder must repay the “ultra vires” amount to the company
- The company is liable to pay tax under section 419 TA 1988, at 25% of the amount of the “ultra vires” payment – though this is repayable when the shareholder repays the money to the company, the way the rules work can mean a long wait for the repayment
- If the “loan” is over £5,000, the shareholder/director will be liable to tax on it as a benefit in kind, unless he pays the company interest on the “loan”.
The basic principle is that when a dividend is paid on a company’s shares, it must be paid at the same rate for each share. Take a simple case of Marxbros Ltd, a company with only one class of shares, held like this:
Groucho 50 shares
Harpo 25 shares
Chico 25 shares
Total 100 shares
If Marxbros Ltd pays a dividend of £10,000, this will be paid as £100 to each share, so Groucho will get £5,000 and the other two will get £2,500 each.
If (perhaps for tax planning reasons) a company wants to pay dividends to some but not all of its shareholders, it is possible for some of them to “waive” their right to some or all of their dividends. They do this by executing a Deed – a formal legal document, signed in front of a witness. Such waivers are generally looked at closely by HMRC, and it is essential to get the procedure right:
- A Final Dividend must be waived before it is declared – that is before the accounts are approved by the AGM.
- An Interim Dividend must be waived before it is paid
- It is important that HMRC cannot attack the waiver as a “settlement” – that is, as a transfer of one person’s income to another:
Suppose Marxbros Ltd has distributable profits of £50,000, and it wants to pay a dividend of £10,000 to Harpo and Chico, but Groucho does not want a dividend paid (perhaps because it would attract income tax at the higher rate in his hands). Grouch can execute a waiver of his right to the dividend, and the company can pay dividends of £10,000 to Harpo and to Chico.
If, however, Groucho waived his rights and the company paid a dividend of £15,000 each to Harpo and Chico, HMRC would say that Groucho had made a “settlement” on them by waiving his right to his dividends. This is because a dividend of £15,000 on Chico’s 25 shares is a dividend of £600 per share, and if Groucho had not waived his rights, the company would not have had enough distributable profits to pay £600 per share (£600 x 100 = £60,000, and the company only had distributable profits of £50,000). Even if the company had paid out all its distributable profits, Harpo and Chico could only have had £12,500 each, so Groucho will be treated as having made a settlement of £2,500 on each of them, and Groucho will be taxed on income of £5,000.
Dividends and Loan accounts
Finally, there is a common practice among family companies of the shareholders drawing out the cash they need during the year, and then declaring a Final Dividend when the accounts are prepared which is sufficient to cover the total amounts drawn. This is a dangerous practice, and is often challenged by HMRC when they investigate a company. The best practice is for the company to pay sufficient interim dividends at monthly or quarterly intervals to ensure that the sums drawn out are covered. If this is not done, then some or all of the following problems may occur:
- Income tax on the shareholder/director on the benefit of an interest free loan during the year
- Tax under section 419 TA 1988 on the company (see above)