Sarah Bradford looks at options for extracting funds from a family company to pay bills where there are no retained profits.
The Covid-19 pandemic has hit many family businesses hard. Depending on the nature of the business, they may not have been able to trade during lockdown.
Alternatively, they may be facing increased costs and reduced turnover as a result of complying with social distancing measures and compliance with Covid-19 secure workplace rules. Supply chains may also have been disrupted or turnover reduced as customers cut back on their spending.
Despite these challenges, company directors and shareholders will still have personal bills that they need to meet. What options are available to them for extracting funds from an unprofitable family company?
A popular and tax-efficient profit extraction strategy for family companies is to pay the director/family employees a small salary and to extract further profits as dividends.
The optimal salary level depends on whether the National Insurance contributions (NICs) employment allowance is available. If the allowance is not available (as is the case in a personal company where the sole employee is also a director) the optimal salary for 2020/21 is one equal to the primary Class 1 NICs threshold of £9,500. Where the employment allowance is available as would be the case in a family company with more than one employee, the optimal salary is one equal to the personal allowance of £12,500.
Once the optimal salary has been paid, it is more efficient to extract further profits as dividends. Although the profits from which dividends are paid have suffered corporation tax at 19%, there are no NICs to pay and dividends are taxed at a lower rate. In addition, all taxpayers are entitled to a dividend allowance of £2,000.
The dividend problem
Dividends must be paid out of retained profits. A company that does not have any retained profits is not able to pay dividends. If a dividend is paid and the company lacks the retained profits to pay that dividend, the dividend is illegal.
The Companies Act 2006 states (at section 830): ‘A company may only make distributions out of the profits available for the purpose.’
Where the shareholder knows or should have known that a dividend is illegal, to the extent that the dividend exceeds the available reserves, the shareholder must pay it back to the company. If they do not do so, HMRC will treat the excess dividend as a loan to a participator, with the result that a ‘section 455 charge’ will be payable by the company if the loan is not repaid within nine months and one day of the end of the accounting period.
Where the recipient is also a director or an employee, a benefits-in-kind tax charge will also arise if the excess dividend is more than £10,000. Where this is the case, the company will also suffer a Class 1A NICs liability.
Paying interim dividends
Many family companies pay dividends throughout the year as the need arises. They may not know whether they have sufficient retained profits to cover those dividends until they prepare their accounts after the year end.
If the company has retained profits brought forward, the dividends paid in the year can exceed the profits for the year. Likewise, making a loss for a year is not in itself a bar to paying dividends; what is important is whether the company has sufficient retained profits brought forward to cover both that loss and any dividends paid out.
To keep on track on the retained profits situation, it is sensible to draw up management accounts ‘in-year’. If these show that there are sufficient reserves available when the dividend was declared, the dividend is not illegal.
No profits: What now?
During the Covid-19 pandemic, a company may be running at a loss, eliminating any retained profits brought forward. Where there are no retained profits, paying a dividend is not an option.
However, the company may have cash in the bank and need to withdraw funds to meet living expenses.
Where this is the case, various options can be considered.
Option 1: Additional salary or bonus
Unlike dividends, there is no requirement for a company to be profitable in order to pay salary and wages. Thus, where the company lacks sufficient profits to pay dividends, it can instead pay a higher salary or opt to pay a bonus instead of a dividend
However, this comes at a cost. Once the personal allowance has been used up, salary and bonus payments will attract income tax in the hands of the recipient, at the rate of 20% where the salary falls in the basic rate band and at 40% where the salary falls in the higher rate band. There are also NICs to pay at 13.8% for the employer and 12% or 2% for the employee. However, the salary and the associated NICs are deductible in computing profits for corporation tax purposes.
Where the payment of the salary or bonus results in a loss, the company can carry the loss back to the previous period, which may generate a much needed repayment of corporation tax.
However, paying a salary or bonus in excess of the ‘optimal’ level is not efficient from a tax perspective, and this route should only be taken where the funds are needed outside the company. If the funds are not needed to pay personal bills, it is preferable to leave them in the company until profitability is restored.
Option 2: Loan
Where funds are needed to tide the family over a difficult period, but it is expected that the company will be profitable once the impact of the pandemic eases, making a loan from the company to the director could be a sensible option. Indeed, it is possible to lend a director up to £10,000 for up to 21 months, depending when in the accounting period the loan is made, without suffering any tax consequences.
The loan can be repaid either by crediting salary or bonus payments or a dividend to the director’s loan account. Alternatively, if the director has funds from outside the company, such as a personal loan, these can be used to repay the debt.
If the loan remains outstanding nine months and one day after the end of the accounting period, the company will have to pay a charge (under CTA 2010, s 455) of 32.5% of the outstanding loan balance. The director will also pay tax on the benefit of the loan if this exceeds £10,000 at any point in the tax year.
Option 3: Rent
If the company is run from home (e.g. from a home office) the company can pay rent for the use of that space.
While the rent is taxable in the hands of the recipient, there are no NICs to pay. The rent paid by the company is deductible in computing its taxable profits.
Option 4: Benefits-in-kind
The company can also look at providing the director with benefits-in-kind. Where the benefit in question is exempt from tax, this is particularly tax-efficient.
For example, the company could provide the director with a mobile phone, rather than the director meeting the cost himself from his post-tax income.
Beware: Covid-19 financing trap
To help businesses affected by the Covid-19 pandemic, various loans were made available.
For example, if the company has taken a bounce-back loan, this must be used in a way that provides economic benefit to the business, such as providing working capital or boosting cashflow.
While it can be used to pay salaries, dividends cannot be paid from the loan – the company must have sufficient retained profits. Nor can the funds be used to make a personal loan to the director.
Where there are no retained profits, options are available for extracting funds from a company to meet personal liabilities. However, it is prudent to only withdraw what is needed and leave funds in the company otherwise.