Something for a rainy day

I had a Zoom meeting with a client last week to review and sign off some accounts. 

The accounts mainly covered ‘pre-Covid’ trading so it was a solid year. The current financial year will be a different story. They are a B2C or ‘Business to consumer’ service business. They were closed and had no sales during the period of lockdown and since then sales have been ‘fair but patchy’. Further restrictions on the horizon make the future uncertain.

But this business is better-placed than most. 

During the better trading years they chose to leave a reserve in the company in case tougher times arose in the future. Tougher times have now arrived, with knobs on and their prudence has been rewarded by having a reserve to fall back on to allow for the inevitable reduction in profits and cash flow this year.

How many of the rest of us showed enough foresight and self restraint to do a similar thing? 

Not many of us I suspect. 

Of course now is not the time for accumulating reserves. Some businesses are still fighting for survival and the majority are probably just ‘getting by’. 

The medium term priority for all businesses must be to return to profitability. Government financial support has helped but we know that this is unlikely to be sustained in the longer run.

Many businesses will have taken advantage of Bounce Back Loans or Coronavirus Business Interruption Loans so cash positions may be relatively favourable. Loan repayments will commence from next year however and it is profit rather than cash which will be the key measure of longer term sustainability.

In a post-Covid world, when it arrives and business fortunes begin to turn, the first priority for many of us will probably not be setting something aside for a rainy day.

One of the lessons of this crisis however is that we all need to become more resilient and prepare for the unexpected. 

Keeping a little bit in reserve, like my prudent and far-sighted client, is something we can all benefit from.

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When the dividends don’t work

Most owner/directors of private limited companies will choose to pay themselves with a mix of salary and dividends.

Usually the most optimal set up is to pay themselves a salary up to the National Insurance Primary Threshold and top up the rest of their income as dividend.

In the current tax year (1920/21) that would mean drawing an annual salary of £9,500. Drawing a dividend of £40,500 in addition to the salary would give a gross income of £50,000. The income tax due on this would be only £2,287. No employee National Insurance would be due but a salary at this level would count as a qualifying year towards State Pension eligibility.

In comparison, personal income tax and employee National Insurance contributions on a £50,000 salary would be £12,358. Some £10,000 higher than the combined salary/dividend option.

The tax saving is much reduced if the combined company and personal tax impact are considered. Dividends are paid after corporation tax (unlike salaries they are not a tax deductible expense) so every £100 of dividend paid instead of salary incurs an extra £19 corporation tax. The company would also pay employers' National Insurance on salary above £8,632 per annum.

Nevertheless, for modest incomes, if looking purely on the basis of tax efficiency the combined salary/dividend option works best and most accountants will recommend this route.

So why wouldn’t an owner/director always choose this option?

There are a some cases where I think the salary/dividend route may not be the best choice:

    1. Where there are a number of senior managers who may not be shareholders

Where there are a number of senior managers who are not shareholders there might be a case for the owner drawing a ‘market rate’ salary for the contribution they make and topping up with dividends if profits are sufficient to allow this. This enables the owner to be transparent about profitability and remuneration with their senior management team. They might also combine this approach with a profit-based bonus scheme. The benefits may outweigh the tax savings gained from the salary/dividend remuneration method.

    2. Where an owner is preparing for exit

As above a ‘market rate’ salary reflecting the owner’s true contribution to the business might be a sensible transition in the years before they exit the business. The remuneration can be easily flexed if they gradually reduce their involvement. As with 1 above a top up dividend can be drawn on top of the salary if profits allow. This can be an added incentive for a business owner to drive the business to generate ‘surplus’ profits after allowing for their management contribution. In this way the business may be more likely to become a standalone investment rather than a lifestyle business.

    3. Where there are several shareholders with varying levels of input

Using salary rather than dividend in this case allows greater flexibility. As with 1 and 2 above dividends can be used as a ‘top up’ on the salary where all the shareholders benefit in proportion to their respective shareholdings.

There’s a saying in tax circles, ‘Don’t let the tax tail, wag the business dog’. 

I think it can apply here. 

It's not conventional wisdom for an accountant to say this but, in some cases, less tangible, business and operational considerations may sometimes override harder tax savings.

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