While there’s a hint of light at the end of the lockdown tunnel, business will take a while to recover. In the meantime you’re taking minimal income from your company, but should you consider increasing this to maximise tax efficiency?

Cash-strapped companies

If your company’s business has been hit by the coronavirus lockdown, chances are it’s the cash flow which has suffered most. In the longer term the downturn is also likely to reduce profits or even result in losses. Oddly, the lack of cash and profits could allow owner managers to extract profits from earlier years tax efficiently.

Previously profitable

Where in previous years your company made profits which you didn’t take as dividends etc., say because you wanted to minimise or avoid higher rate income tax, they will show as reserves on the balance sheet of your firm’s last accounts. You can take them as dividends now, to the extent that any subsequent losses (if any) haven’t reduced them.

Example. Acom Ltd has generated little income in the last seven weeks and since the start of the tax year its director shareholders, Sally and Nick, have taken virtually no income from it as the company has very little cash available. Acom’s accounts for the year to 31 December 2019 showed reserves of £250,000 while up-to-date interim accounts show losses for the current year of £5,000. Sally and Nick expect Acom to achieve a modest profit by the end of 2020 but only if they keep their income from Acom at the current low level. They plan to top up their income from savings. The trouble is this will mean they will barely use their tax-free allowances, let alone their basic rate band of tax. Not a very tax-efficient position.

Tip. Sally and Nick could declare dividends out of Acom’s reserves to use their basic rate bands. The maximum rate of tax they would pay on the dividends would be 7.5% making it a very tax-efficient way to extract some of the £250,000 profit reserves. So while it seems counter intuitive to pay a dividend in a year when the company is struggling, it can be tax efficient.

Procedure. Before you can access previous profits (reserves) company law requires that you review the subsequent finances to establish that the profits haven’t been eroded or the extent to which they have. Only then can the directors legitimately decide to pay an interim dividend. For small owner-managed companies, the procedure is less formal than it sounds (see The next step ).

Trap. If a dividend exceeds a company’s profits it’s said to be ultra vires, i.e. beyond the rights of the directors or shareholders to pay. You might also see them referred to as illegal or unlawful dividends. Company law means that such excess dividends will usually be treated as loans to shareholders.

Isn’t cash needed to pay a dividend?

You might think that Acom’s lack of cash poses a significant hurdle that Sally and Nick need to clear if they are to make use of the Tip and pay dividends from reserves. The good news is that it isn’t a hurdle at all. The dividends are treated as paid for tax purposes when they are recorded in the company’s records. Typically for director shareholders this is as a credit to their directors’ loan accounts. No cash has to leave the company so the current shortage of cash is no barrier to tax-efficient profit extraction.

If it seems that you won’t use your tax-free allowances or basic rate band for 2020/21, check if your company has profit reserves from which it can declare dividends. For tax purposes they can be paid without any cash leaving the company meaning that you can maximise tax efficiency for profit extraction even when current income is down.

This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.