Bonus versus dividend

The most common methods for director/shareholders to reward themselves are bonuses and dividends. When directly comparing the cost of dividends and bonuses, it often appears as though dividends are cheaper. This is illustrated by the example below.

Example - where the small companies rate of tax applies

Christie is to receive a bonus of £60,000 after all taxes from his family company. He has a marginal income tax rate of 40% (32.5% on dividends) for 2004/05 and already has earnings above the employees' upper earnings limit for NI purposes, so that any bonus will be liable to employees' NI at 1%. The company pays corporation tax at the small companies' rate of 19%.

The calculation set out below compares the cost of paying a dividend rather than additional remuneration to Christie for the tax year 2004/05.

Christie	Dividend £	Bonus £
Dividend/remuneration	80,000	101,695
Less: National Insurance (1%)		1,017
Add: Tax credit (1/9)	8,889
	88,889
Less: Income tax (32.5%/40%)	28,889	40,678
	_______	_______
Net receipt	£60,000	£60,000
Company	Dividend £	Bonus £
Payment by company	80,000	101,695
Add: Employer's NI (@ 12.8%)		13,017
		114,712
Less: Tax relief (@ 19%)		21,795
	_______	_______
True cost to company	£80,000	£92,917

However, it should be borne in mind that there is no tax relief for the company on the payment of a dividend. In addition, without remuneration, state benefit and pension entitlements may be affected and it may also be difficult to make pension contributions. Consequently, a combination of both dividends and bonuses can create the best of both worlds.

Another consideration when thinking about dividends is that the Inland Revenue may challenge the legal validity of dividends, so that complying with the company law formalities of AGMs, relevant paperwork and the availability of company reserves are highly important and these formalities should not be overlooked.