When looking to extract profit from a close company, the usual wisdom is that dividend payment is more tax efficient than additional
salary or bonus. However, as the current dividend regime erodes the tax advantages of dividend extraction, it’s a good time to review the overall position.
Timing, Flexibility & Opportunities
Bonuses differ from dividends in being a deduction from company profits, and are taxed on the director as employment income, rather than as investment income.
Thus, unlike dividends, bonus payments can reduce corporation tax. The other side of the coin is that they attract National Insurance contributions.
Timing of bonus payments and the balance between dividend and bonuses is best reviewed before the end of the company’s accounting period. By adjusting the mix and payment dates, it is possible to optimise the timing and amount of both company and director tax liabilities. Bonuses win out in some specific circumstances (considered below); creating planning opportunities to secure the best outcome, particularly for shareholder directors. However, as shown by some recent Tribunal decisions overturning tax planning arrangements using directors’ bonuses, it is all the more important to be clear on the boundaries and alert to the consequences.
Finally, care needs to be taken to recognise both tax and accounting requirements (FRS 102/105 provisions).
Timing of Payroll Taxes Payment and Company Deduction
A director’s bonus counts as income from employment. It is thus subject to PAYE and National Insurance contributions.
The timing of a bonus payment is particularly important. From a corporation tax perspective, payment has to take place within nine months of the end of the accounting period to which the bonus relates. The date when a bonus is approved, and the director has an enforceable right to it, is the occasion for payment of
National Insurance and PAYE, even if the bonus is not actually paid until later.
For employees who are not directors, the effective date for PAYE purposes can still be deferred by adding conditions or restrictions. Until the restriction or condition is met, the bonus will not be available to the employee, and payroll taxes will not be due.
But ITEPA 2003, s. 18(1) Rule 3(a) means that bonuses for directors cannot be deferred simply by adding conditions. Directors’ bonuses are liable to income tax and National Insurance from ‘the time when sums on account of the earnings are credited in the company’s accounts or records’. This applies ‘whether or not there is any restriction on the right to draw the sums’.
From a company perspective, the articles of association may mean shareholder approval is necessary before a bonus can be paid. Combining these factors with the requirement for a tax efficient decision for the individual director needs careful consideration. A bonus may need to be voted in principle before the accounting year end, even if the detail is refined later.
Bonuses: Key Advantages
- Where a close company has grown through equity investment, bonuses allow remuneration to be directed towards specific directors (such as the original founders of the business) rather than offered to all shareholders, including new equity investors.
- Dividends are a distribution of company profits and can only be paid out of realised profits. By contrast, bonuses are a charge against profits, and may be paid even where a company has no available realised profits.
This means that bonuses can be paid in circumstances where the payment of dividend is unavailable, for example where a company has been making losses. This brings new opportunities; for example, bonuses can be used to clear an overdrawn director’s loan account where a company has no realised profits. This can be useful when a company is experiencing difficult trading conditions or is approaching insolvency.
- Bonuses can be deducted from company profits as long as they are paid within nine months of the accounting year end. This means that the level of bonus can be chosen after the company profit is known and adjusted to minimise corporation tax liability.
- Bonuses can be paid in kind, or by offset, rather than in cash; this can be useful in conditions where a company is experiencing cashflow difficulties.
- Performance-related bonuses can be another means of motivating key individuals and directing remuneration only to specific people.
- Bonuses can be waived, but care is needed to make waivers effective and avoid the company being liable for payroll taxes on any waived bonus. Usually, the company is liable for payroll taxes once the right to a bonus is enforceable. Once this has happened, waiver is ineffective; the director will still be taxed on the bonus as employment income and payroll taxes will be due (see HMRC’s Employment Income Manual at EIM 42725).
- A general agreement to pay bonuses without it forming part of a contractual employment right is unlikely to establish an enforceable right, but once a pattern of bonuses has become customary and expected, employees and directors may have an enforceable right to them.
Two other traps with bonuses have been highlighted in recent Tribunal decisions – personal liability of directors for payroll taxes in company insolvency, and failed tax planning schemes with directors’ loans. These are considered in more detail below.
Personal Liability of Directors for Payroll Taxes in Company Insolvency
Shareholder directors often take a low salary during the year and vote the balance of their remuneration as dividends at the year end. This can be a tax efficient strategy, and often involves directors drawing on their loan account through the year and clearing any overdrawn balance on the director’s loan account with the year-end dividend.
But when a company hits difficult trading conditions, it may not have sufficient available profits at the year end from which to pay dividends. The director is therefore left with an overdrawn loan account and a number of potential problems.
If the loan account is still overdrawn nine months after the year end, there may be a ‘section 455 charge’ on the outstanding loan balance as a distribution to a participator. In some circumstances, there could also be a benefit in kind charge in respect of interest. Furthermore, if the company enters insolvency, the director may become personally liable to repay the loan account balance to the company. To cut through such difficulties, it is possible to declare a bonus, the net amount of which, after payroll taxes, neatly extinguishes the liability on the overdrawn loan account.
The big question here is what happens if the payroll taxes are not paid to HMRC: can the director become personally liable?
Book entries are sufficient to be counted as ‘payment’ in many circumstances. For example, a book entry crediting a bonus against a director’s loan account is effective ‘payment’. But can payroll taxes be treated as ‘paid’ simply by making a book keeping entry of the liability to HMRC, when a company knows it will not be able to come up with the cash?
Clarification has been provided by the Upper Tribunal case of Stephen West  UKUT 0100 (TCC). The Upper Tribunal overturned the First Tier Tribunal decision and reached the conclusion that payroll taxes could not be treated as paid simply by making entries in the company accounts or records, where it was clear when the entries were made that the taxes could not possibly be paid.
This means HMRC are entitled to transfer liability for income tax to the director personally (under the Income Tax (Pay As You Earn) Regulations 2003 (SI 2003/2682), reg. 72) and liability for Class 1 primary National Insurance contributions (under the Social Security (Contributions) Regulations 2001 (SI 2001/1004), reg. 86).
So, where a company is on the brink of insolvency, payroll taxes on any bonus used to clear a director’s loan account would need to be paid to HMRC to avoid the possibility of the directors becoming personally liable if the company becomes insolvent.
Tax Planning Arrangements with Directors’ Loan Accounts
There have been various planning schemes proposed in the past involving arrangements where bonuses are declared, but fulfilled through extinguishing the debt on a director’s loan account rather than being paid in cash or book-keeping offset.
The aim was for the amount of the loan written off to be taxed at dividend rates (under ITTOIA 2005, s. 415). The director would give up any right to the bonus, in exchange for the loan write-off. The overall anticipated result was that the director received the benefit of extinguishing an overdrawn loan account, but avoided the payroll taxes associated with payment of bonuses.
It is doubtful if such arrangements would pass the standards for tax planning set out in the Professional Conduct in Relation to Tax agreed by the main tax and accountancy bodies.
This scenario was recently examined in Esprit Logistics Management Ltd (TC06517)  UKFTT 0287 (TC).
The Tribunal concluded that ITTOIA 2005, s. 415 did not apply. Rather than the transaction being a loan write-off, it was settlement of the loan by way of a declared bonus, the result being that payroll taxes were due on the amount of the bonus used to clear the loan.
Finally, bonuses can be overlooked as a management tool for close companies. For optimal use, care is needed with the detail.