Whenever a company pays a dividend, all shareholders receive a payment that relates to how many shares they have, and of what type. Many SMEs will use dividends as a method of payment for employees, but in order to differentiate payment amounts, you will need different types of shares. Each type of share will have its own value and payment rate, which allows companies to choose who to pay, when and how much. The most straightforward way to achieve this is by using alphabet shares. But what are they, and how do they work?
What are alphabet shares?
If you run a limited company, you’re required to create and distribute shares, which represent a piece of the company. It’s like cutting a cake – except you’re cutting the ownership of your company into slices instead. So, if your company has 1 share and you own it, you own 100% of the company. If your company has 2 shares and you own one, you will own 50% of the company.
Alphabet shares is a simple method for differentiating between types of shares. They keep shareholding and dividend distribution clear and straightforward, especially if they are created when the company is incorporated. They are called alphabet shares because they are often named as A shares, B shares and C shares, and often rank equally in most aspects – like voting rights. But they differ in value (and therefore payment amount) and payment schedule. This gives the company flexibility to pay dividends in a method they see fit to each shareholder. This could be for any number of reasons, from experience to different tax brackets and personal circumstances.
How do they work?
It can sometimes be a bit tricky to visualise how this sort of thing would work in practice, so let’s look at an example.
A construction company is owned by Callum and Lia, a husband-and-wife team. Each of them holds 1 ordinary A share in the business, making them 50/50 partners. They want to take out £100,000 from the business to pay for an extension on their own home. With the dividends structured as they are, they would each need to take a dividend of £50,000 and pay the relevant personal income tax on it.
But what if Callum held 1 ordinary A share, but Lia only held an ordinary B share? This would allow the company to pay different amounts to each person. So, Callum might be paid £40,000, and Lia £60,000. This would help keep their overall dividend amounts below personal allowances and could help them manage their personal tax more efficiently.
Callum and Lia could have set up the company with A and B shares for a few different reasons. For example, Callum may have started the business a few years ago, and brought on Lia recently to help with the admin side of things as the business grew. B shares means Lia could be paid properly and flexibly, but not give her voting rights on the future of the company – which are only automatic for A shares. This is the true flexibility of alphabet shares, and why so many businesses choose to use them.
Why use alphabet shares in your business?
As we already mentioned, alphabet shares allow companies to be completely flexible in what money they pay out and to who. They can be used just for directors, or many businesses use them as a method of paying employees, with the value being redeemable at par value (so £1 on a £1 share), with no voting rights and shares being returned when the employee leaves the company.
However, businesses should be careful in the way they set up their shares, otherwise they could end up in trouble with HMRC. There have been cases in the past where companies have set up shares in order to pay bonuses as dividends rather than employment income – HMRC won the court cases and the companies were told to pay NIC. So, our recommendation is to speak to an accountant about how your company is set up and what you would like to do in terms of shares before you create new ones.
How do you set up alphabet shares?
Alphabet shares are relatively straightforward to set up, once you understand what they are and how you want to use them in your business. Typically, the process would look something like this:
- Create a new class of shares for each of your chosen share type
- Set the new classes of shares out in your company’s Articles of Association (a record that specifies the regulations for a company’s operations and defines the company’s purpose)
- Ensure the new articles detailing the new share classes are adopted by special resolution (written is preferred)
- Decide to either allot new shares of the classes concerned, or have existing shares converted to the new classes
- Both directors and shareholders consider and approve the changes to the company articles
- Send notices of the statutory forms and resolutions to Companies House
At Purple Lime our job is to make sure your business does what you want it to in the most tax efficient way possible. We work closely with you to advise on company structure, dividend payments and share allocation, as well as working with directors to plan their personal tax returns to ensure everything is handled in the most efficient way possible. If you would like to know more, please get in touch by emailing firstname.lastname@example.org or calling us on 01249 691360.