Save tax using the dividend allowance
Paying dividends to family members can save tax, but only if the shares are acquired without triggering a tax penalty.
The dividend allowance allows every individual to receive up to £5,000 of dividend income per year, taxed at 0%. It doesn’t matter what rate of tax the individual pays on their other income, the first £5,000 of dividend income will be taxed at 0%. Estates of deceased persons are not entitled to the dividend allowance which may create problems for executors in the future.
This tax-free slice of income can be exploited within family companies by paying small dividends to the spouse, adult offspring, or other relative of the company owner. However, those individuals can only receive a dividend from the company if they hold a share which entitles them to receive the dividend.
My earlier article, Giant mistake leaves taxpayer with huge bill, demonstrates what can go wrong if dividends are paid to someone who is not a shareholder. It is thus essential to follow the correct company secretarial procedures when issuing shares and paying dividends.
Shares in issue
Your first step should be to examine the amount of authorised and issued share capital for the company. Many micro-companies operate for years with only one share in issue. If the company owner wants to spread their shareholding among members of their family, the owner needs to hold sufficient shares in order to pass some of his or her shares on.
Where only a few of the authorised share capital have been issued, more shares may need to be issued. Different classes of shares (eg A-shares, B-shares) will permit dividends to be paid at different rates and at varying times to the holders of each class. This will allow a good deal of flexibility in the payment of dividends, but beware of the settlements legislation (see below).
The different classes of shares can carry different rights to the assets on a winding-up or votes, but if the long term intention is to allow all shareholders to take advantage of entrepreneurs’ relief, the shares should carry also carry voting rights. To qualify for entrepreneurs’ relief 10% rate of CGT, the shareholder must hold at least 5% of the ordinary share capital, and 5% of the voting rights of the company. Preference Shares which have only an entitlement to a fixed dividend are not part of the ordinary share capital (ITA 2007, s 989).
Gift of shares
A gift of shares between spouses or civil partners will be treated as a no gain, no loss transfer for CGT, so no taxable gain arises. Gifts of shares to other individuals can give rise to taxable gains. However, such gains could be held-over under TCGA 1992, s 165, assuming the company is trading and doesn’t hold significant amounts of non-business assets. Small gains may be covered by the donor’s annual exemption (£11,100).
If the gift of shares is regarded as a settlement rather than an outright gift, the dividends arising from those shares are treated as the income of the donor not of the recipient of the shares (ITTOIA 2005, ss 619-648). This issue was explored in depth in the case: Jones v Garnett  UKHL 35, which was eventually won by the taxpayer.
To avoid the settlements legislation applying, any shares issued to or given to family members should be ordinary shares with full voting rights and rights to capital on a winding-up. Shares should not be given to children aged under 18, as such a gift is likely to be treated as a settlement.
Shares given to employees of the company can be subject to income tax as employment-related securities (ITEPA 2003, s 421B), but there is a general exemption from that legislation for gifts made as part of a family relationship.
Subscribing for shares
As an alternative to gifting shares, family members could subscribe directly for their shares. They should pay for those shares using funds they have earned or received from other sources, not out of from funds gifted by the company owner.
Although the dividend allowance taxes up to £5,000 of dividend income at 0%, that income uses up part of the tax band it falls into. It is also included in the calculation of the high income child benefit charge, and for £100,000 threshold that withdraws personal allowances.
The tax effect on the recipient of the dividend should be calculated before any dividend is declared or paid. Dividends must not be paid unless there are sufficiently distributable reserves held within the company.