How contractors can avoid 'doing an Adele'

Adele: "Hello, it’s me"

HMRC: “I was wondering if…you realise that you owe us £2.5 million?!”

Alright; it’s unlikely the taxman’s exchange last month with award-winning singer Adele partly mimicked the lyrics from her latest hit single ‘Hello.’ But contractors will want to ensure that they too don’t copy her when it comes to dividends, writes Chris Conway, managing director of Accounts & Legal.

That’s because Adele has had to pay £2.5 million to HMRC after one of her limited companies accidentally paid its only shareholder (i.e. Adele herself) too much in dividends. With music industry insiders describing the incident as an “embarrassing mistake” for the superstar, here’s how IT contractors can avoid ‘doing an Adele’.

Sole director

Like many contractors (and other self-employed professionals), Adele has set up several limited companies in order to manage her business interests more effectively and more tax-efficiently. She is the sole director of both Melted Stone Limited and Melted Stone Publishing Limited, through which she receives royalty payments and other income before extracting the profits as dividends.

A lesson for contractors

However, how one of those ‘Ltds’ calculated a dividend payment last year should be a lesson for all contractors. The government has strict rules in place (the Companies Act 1985, section 263, in case you’re keen to read Parliament’s lovely prose) that are designed to ensure that corporation tax is paid before distributions are calculated, and any dividends that are then issued by a limited company aren’t greater than its accumulated profits. It is those rules that have resulted in Adele’s dividend mix-up.

Salary or dividend?

Contractors trading through a limited company can choose to pay themselves a salary even if their business makes a loss, whereas dividends can only be paid if the business is profitable. When the business is profitable many contractors choose to pay themselves a small salary (such as an annual salary of £8,060, in order to ensure they don’t create a National Insurance liability), before distributing the remaining profits as dividends.

However, Adele’s case should be a reminder to contractors everywhere that although this arrangement is definitely the most tax-efficient, corporation tax must be paid before dividends are calculated, and the size of the Ltd’s ‘distributable reserves’ (i.e. its accumulated profits) after corporation tax will determine how large the dividend can be.

Don’t do an Adele

There is no suggestion whatsoever that Adele deliberately tried to avoid paying her fair share to HMRC, and taking advantage of the tax efficiencies available to limited companies is not only allowed, it’s also smart.

However, although £2.5 million may be little more than a drop in the ocean for someone with Adele’s wealth (who was recently recognised as the UK’s richest ever female musician with a net worth of approximately £88 million), it’s definitely better to pay the right tax upfront and give the ‘Cold Shoulder’ to the prospect of an unexpected tax bill further down the road.

So, if you’re a limited company contractor just make sure your dividends are calculated after your corporation tax bill, and that they aren’t larger than your distributable reserves. Do that and you should be ‘Right as Rain’.

Editor's Note: Related Reading

How to avoid personally paying your Ltd's tax bill

IR35: Contractors 'face 13% income drop from April'

2016 Limited Company Dividends Tax Guide