Why must you maximize dividends when you have the opportunity?

The Coronavirus has resulted in chaos on dividends as a method of profit extraction for certain small business owners, putting them at a tax disadvantage for the foreseeable future. How may a future event like this be avoided and mixmize dividends?

Profit extraction and tax performance

As a director shareholder, the standard tax advice is to accept a small salary (up to the NI secondary threshold of £8,840 per year) and supplement it with dividends to optimize tax and NI efficiency. The issue is that dividends may be paid exclusively from your company net profits.

Pitfall. No profits mean no dividends.

This means, if your company is losing money and you depend on its profits, you will decide either to increase your salary, which is sometimes costly in terms of tax and national insurance contributions or borrow from it. However, this may perhaps be uneconomical in terms of tax, corresponding to the method in which the loan is paid back.

Taking full advantage of dividends.

Even if you don’t need the money right now, it may be tax and NI efficient to take as much as possible in dividends when profits allow, even if you don’t need it right away. The reasons for this may be seen in the following two instances.

Example – lower dividends.

Alex and Mark are directors and equal shareholders of PR Tech Ltd, which they founded in 2018. By the end of its 2019 financial year, it had accumulated a profit of £160,000. It allocated £110,000 in dividends to Alex and Mark (in addition to their salary). PR Tech Ltd was afterwards adversely affected by the Coronavirus, and its surplus profit was reduced by 2020. It suffered losses of £40,000 at the close of its 2020 financial year. According to Alex and Mark, PR Tech Ltd will not return to profit until the financial year 2022. While the company has enough funds to pay dividends, the no-profits rule restricts it from doing so. For Alex and Mark, the only options are a tax-inefficient salary or borrowing from the company.

Example – maximum dividends.

The circumstances for PR Tech Ltd, Alex and Mark, is similar to the previous scenario, with the exception of that the company paid out all of its £160,000 profit as dividends in early 2019 and early 2020, before the financial impact from the Coronavirus. Alex and Mark did not need all of the dividend income at this point, so they left the surplus in PR Tech Ltd as a credit to their loan accounts. They may withdraw the funds at a later date without incurring any tax or NI obligations.