As a general rule, dividends are the most tax efficient way to get income out of your company. But these can only be paid where you’re making a profit. So what will the Taxman say if you pay dividends from a loss-making company?
Simply having enough money in the bank doesn’t mean you can pay yourself a dividend. As it’s actually a distribution of profits, if you don’t have any there’s nothing to distribute. For example, if you started a company with an injection of cash, say, from your savings, you would have money in the bank. But on day one of trading you won’t have made any profit so you can’t pay a dividend.
When can you pay a dividend?
The good news is that you don’t have to wait until your annual accounts are prepared before you can say whether you’re in profit. A reasonably accurate figure can be worked out at any time with just a basic accounts system. A good bookkeeper can help you here. The trouble is it may be a while before a new company becomes profitable or trading conditions might change so later losses eat into previous profit you’ve already drawn as dividends. What then?
Profits to losses
If you’ve drawn dividends during the year but your annual accounts show a loss, or a profit less than the amount of dividends you’ve taken, you might face some tough questions from the Taxman. In practice, where you’ve taken money from your company which can’t count as a dividend, the Taxman’s first response is likely to be that it counts as salary. If he’s successful in this line of attack it can cost thousands in PAYE tax and NI.
Countering the salary argument
Where an intended dividend fails you can counter the Taxman’s argument that it must be treated as salary by quoting his own guidance back at him. His Employment Income Manual contains two helpful sections EIM42300 and EIM42320. These correctly say a director only becomes entitled to salary etc. when approved by the shareholders or board or as agreed in advance in a contract. To put the matter beyond doubt it’s a good idea to specify in a director’s service agreement that the level of salary will be set annually or at other times only by express approval by the board. If you’re a single shareholder/director company there won’t be a board; instead, you can include a similar clause added to the articles of association. If a payment isn’t a dividend or salary etc. it will count as a debit to your director’s loan account. If this is in credit, say because you put money into the company (other than share capital), it will reduce the amount owed to you. If not, you’ll owe your company and this falls into another less costly set of tax rules that we’ll look at another time.