I operate a small company which is owned by me, my husband and our two children. My accountant has recently advised the use of alphabet shares. What are these and how do they work?
A company’s constitution is contained in its Memorandum and Articles of Association. Unless the Articles state otherwise, all shares rank equally, and if the directors recommend a distribution of profits through a cash dividend, each shareholder is entitled to an pro rata share of the total, by reference simply to the number of shares held.
For mainly tax planning reasons, it is sometimes desirable for the directors to have the ability to declare different dividend rates to different shareholders. This may be the case for instance where one of the shareholders is also an employee and pays income tax on his salary, whilst another does not work full-time. Differential dividends can be used to optimise personal tax allowances.
Many small companies will therefore create different classes of share and give them different names: A, B, C etc (hence alphabet shares). This then allows the directors to declare different dividends for each class of share.
Alphabet shares are created by amending the articles of association. It is important to record the shareholders’ agreement to how differential dividends are to be determined. This is not a problem when all shareholders are of the same mind, however, if a dispute arises and there is no such agreement, the directors can be challenged as to the basis on which they failed to treat all shareholders fairly. It could be tricky to justify paying one shareholder a smaller dividend than another.
To avoid disputes, companies should make things as clear as possible in the Articles of Association, or at the very least through a formal written agreement signed by all shareholders.