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How to declare a bonus and reduce your corporation tax liability

How to declare a bonus and reduce your corporation tax liability
How to use bonuses effectively to reduce corporation tax. Business owners have been using bonuses to reduce their corporation tax liabilities for a long time - in this blog you will learn how to avoid the pitfalls of this strategy and to make sure that you get the tax deduction that you are looking for.
 
The classic situation we find is that the directors discover that they have made good profits which give rise to a higher corporation tax bill than the really want to pay, so they declare a bonus thereby reducing the company's profits and they pay the PAYE and national insurance on the bonus at a later date when they process it through the payroll. Sounds great but will it work? Well it is all in the timing!
 
Imagine Mr & Mrs Smith note that their company is doing really well, and they are worried about the impending corporation tax liability. Mr Smith decides in early December that he and his wife will each be paid a bonus of £20,000 sometime after the year end which they will accrue in their accounts to 31 December 2020.
 
In theory, you can defer a bonus for nine months so, in Mr Smith's case so long as the bonus is paid by 30 September 2021 then he is allowed to make a deduction from the company's profits in his December 2020 accounts - or can he?
 
There are special rules for when directors' bonuses should be taxed, which is the earlier of: -
1. When payment of the bonus is made.
2. When the director becomes entitled to be paid.
3. The date of which the earnings are recorded in the accounts.
4. Where the amount of earnings is determined before the end of the year to which they relate.
5. Where the amount of earnings is determined after the end of the period to which they relate, the date the amount is determined.
 
In Mr Smith's case, he has decided that he and his wife will each receive a bonus of £20,000 before his company's year-end and so point four above is triggered and the bonus should be taxed when he decided on the amount to be paid i.e. in the December 2020 payroll run. This is probably well before Mr Smith wanted to pay the PAYE and national insurance on the bonuses.
 
Accountancy rules allow us to make a tax allowable accrual when
- there is an obligation to pay an amount at the end of the accounting period
- the amount of the payment can be reliably estimated.
 
So what should Mr Smith have done in order that his bonus accrual be allowed for corporation tax purposes and still allow him to process the bonus through his payroll in the following year?
 
At the Board meeting held in early December Mr & Mrs Smith should have determined that as the company was performing strongly that the directors should take a bonus and a bonus pool of £40,000 is agreed on. How much of the £40,000 is paid out and to who will be decided at a later date once the annual accounts have been drawn up.
 
If this had been agreed at their December Board meeting then the company will have made a commitment to pay out £40,000 in bonuses and this commitment existed at the year-end so that it can be included in the accounts to December 2020 and it can be reasonable estimated.
 
Finally, only when the year-end accounts are prepared will each directors' entitlement be determined so for PAYE purposes it should be processed in the month when the exact bonus is decided upon.
 
As can be seen, directors need to be careful in declaring bonuses if they are to be certain that they will get a corporation tax deduction in the period in which they want it and pay over the tax and national insurance on the bonus also when they want to pay this over.
 
We would recommend that all company directors give consideration to whether or not they want to declare a bonus in the final two months of their company's accounting year and if you contact us we will assist with this decision and ensure that you have all the paperwork in place to support your bonus declaration.
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