Cutting Your Corporation Tax Liability Through Bonuses
Corporation tax is paid on profits accrued by a limited company or unincorporated association. There are a number of expenses that can be offset against an organisation's corporation tax liability; one of the most important of these is any salary paid to employees or directors (see our article Cutting Your Corporation Tax Liability Through Expenses). Any salaries that are paid will reduce the net profit of the organisation and therefore, by definition, will reduce the amount that must be paid in corporation tax.
Sometimes, however, organisations have surplus profits that they wish to remove and give to employees. There is constant debate as to whether or not a bonus is the most tax efficient way of doing this. However, it is undeniable that in certain circumstances bonuses can be used to mitigate an organisation's liability for corporation tax.
Corporate and Personal TaxIn order to understand the potential tax benefits of bonuses, it is useful to look at the way in which profits are treated inside and outside the company structure. In the first instance, profits that remain within the company are still subject to corporation tax. However, once they are removed and given to individuals in addition to a salary, the responsibility for paying tax on this sum is passed to the recipient.
The tax that must be paid on the money alters from corporation tax to personal Income Tax. This can have highly beneficial results for the company's financial situation as tax relief is available on bonus payments.
A bonus is not, however, the only way of extracting surplus profits from a company. In a large number of smaller companies, those who own the organisation are also the key shareholders. This, of course, gives them an entitlement to dividends, although this entitlement is often forgotten. In the case of small businesses, individual owners' finances and the finances of the company are likely to be inextricably linked; this adds another dimension to the question of whether bonuses or dividends are the most tax efficient method.
Dividends and BonusesWhen looking at this question, it should be noted that dividends and bonuses are treated differently by the personal tax schedule. A bonus is, for tax purposes, counted as part of the recipient's salary, meaning that it is subject to income tax at the normal rate. Dividends, however, are entitled to a tax credit of 10%.
Furthermore, basic rate taxpayers are not required to pay the difference, meaning that dividends are essentially free of income tax for these individuals. If, however, the individual is a higher rate taxpayer, they will be required to pay the difference between the tax owed and the tax credit.
From a corporate point of view there are also a number of factors to be considered when choosing between bonuses and dividends. Primarily, these revolve around the fact that there are effectively three bands of corporation tax: a 'small business' rate of 20% for those with profits up to £300,000, and a main rate of 21% for those with profits over £1,500,000. Marginal relief is available for firms in the middle. From 1 April 2015 there will be only one coporation tax rate, this will be set at 20%.
This means that the gross amount available as a bonus or dividend (the equivalent amount before tax relief) will be different depending on the company's profits.