A guide to limited company dividends

Dividends are an important financial tool for limited companies. They enable owners to reward shareholders for their investment and they provide a tax-efficient form of remuneration for company directors.

This guide explains the source of limited company dividends, how they are distributed and their tax implications for shareholders and directors.

Dividends and profits

Limited company dividends represent the amount of money available to pay shareholders and directors from retained profits after paying Corporation Tax and other liabilities. Retained profits can consist of current year’s profit, together with any profit not used in earlier years.

For example, if a small business makes a profit of £15,000 in its current year and has unused profit of £4,500 from earlier years, a ‘pool’ of £19,500 is available for dividends or other purposes.

It is good business practice to keep part of the profit to cover future contingencies or for reinvestment in the business to support growth; the balance is available for dividend payments. The amount available for dividends is known as ‘distributable profits’.

Related: 11 ways to reduce corporation tax

Declaring a dividend

Before paying any dividends from a limited company, the directors must take a formal decision at a board meeting to ‘declare a dividend’. This process is mandatory, even if the company has only one director.  The decision must be recorded in minutes of the meeting and communicated to all shareholders.

A company can declare a dividend at any time of the year. Timing is not tied to the financial year end and a company can make several dividend declarations during the year. Timing and frequency are only limited by the availability of funds to pay the dividends.

Typically, limited companies make annual dividend declarations, although they could choose to make them every six months or quarterly so that shareholders are aware of upcoming announcements.

Limited companies must not declare a dividend if there are insufficient funds in retained profits. HMRC class that an illegal distribution and may impose penalties or take further action.

Allocating dividends

Directors must also decide how to allocate the dividend to shareholders. Depending on the number of shareholders and the value of the distributable profits, they may decide on a fixed amount per share for all shareholders.

For example, if a company declares a total dividend of £10,000 and shareholders hold a total of 500 shares, each shareholder could receive £20 per share.

Distribution of limited company dividends is generally based on the amounts or proportions set out in shareholder agreements. A shareholder owning 35 percent of the company’s shares, for example, would have the right to receive 35 percent of any dividend declared. However, the decision can be more complicated if a company issues different classes of shares.

Shareholders with preference shares, for example, are first in line to receive any dividends. They may also have an agreement that gives them rights to a fixed proportion of any dividend, which could lead to other shareholders receiving less in a year of lower profits.

Some shareholders may hold capital-only shares, which gives them voting rights on company decisions, but no rights to a dividend payment.

Individual shareholders can also waive their rights to a dividend. They may do that out of concern that sufficient funds are retained in the business.

Issuing dividends to shareholders

After declaring a dividend, the directors must issue a voucher for each shareholder, give a copy to the shareholder and retain a copy in the company’s records.  Each voucher must include the following information:

• Date of issue

• Company name

• Shareholder’s name and address

• Total number of shares held

• Total dividend payable

• Signature of authorised director or company secretary.

Shareholders and taxation

Shareholders who receive dividends from a limited company must declare the amount to HMRC and pay Income Tax at the appropriate rate. Shareholders who file their taxes through Self-Assessment should record the dividend in the appropriate section. Shareholders who don’t use Self-Assessment should inform HMRC by post or phone.

Shareholders can receive dividends worth £2,000 tax free in a year. Above that point, they pay tax on any dividends from a limited company at a rate based on their Income Tax band:

• Basic rate taxpayer – 8.5 percent tax on dividends

• Higher rate taxpayer – 33.75 percent tax on dividends

• Additional rate taxpayer – 39.35 percent tax on dividends

Our guide ‘How are dividends taxed in the UK’ provides more information.

Related: Year-end accounts checklist for small businesses

Dividends for directors

Directors of limited companies may be shareholders, taking their dividend in the same way as other shareholders. However, they can also take dividends as part of their remuneration, which can provide significant personal tax benefits. Our guide ‘How much dividend can I pay myself tax-free’ provides more details.

There are a number of ways for directors to take money from limited companies as personal income. These include salary, bonus, dividends, pension contributions, directors’ loans and private investments. Some are more tax efficient and some provide longer-term income, so it’s important for directors to understand the timing and implications of tax on dividends from a limited company before making any decisions.

Related: A List Of Key Points Of Legislation That Affect Employers In A Business Environment

Salary or dividend

If a company decides to pay a salary to a director, the figure is treated as a business expense and can be deducted from company profits, reducing the amount of Corporation Tax due.

However, it’s important to set the right level of salary to maximise the total Income Tax and Corporation Tax benefits. A higher salary might attract more Income Tax, outweighing any Corporation Tax benefits.

Paying a salary to a director will also attract Employer National Insurance contributions if the salary is above the National Insurance thresholds.  This would mean that a director earning above the threshold would, in effect, pay National Insurance contributions twice.

One of the most efficient alternatives is to pay directors a dividend as part of their remuneration. Dividends are tax-efficient for three main reasons:

• They attract a lower rate than Income Tax, saving tax for the director.

• There is a separate dividend tax allowance that is in addition to the Personal Allowance. This allowance is £2,000 before any tax is due.

• They do not attract National Insurance contributions. However, paying a director only by dividends has a number of disadvantages:

• Dividends cannot be deducted from pre-tax profits, so they do not reduce Corporation Tax liability.

• Because no National Insurance contributions are due, the director would not accrue any qualifying years for the State Pension.

• Income tax would be due, even though the rate of tax is lower.

• Dividends are based on profit and can vary considerably.

• Dividends are generally paid annually, which could create personal cash flow problems for directors.

Combining salary and dividends

In many cases, a combination of salary and dividend is the most tax-efficient solution, as this example from our article ‘Are dividends always more tax-efficient than salaries for small business owners’ shows.

Take professional advice

Making the right decision about distributing dividends or withdrawing money from your business for personal use can be complicated and time-consuming. Our team of small business accountants are highly-experienced in helping companies with professional advice that can maximise income while reducing tax liabilities.

Get in touch with us today for further advice on 0207 043 4000 or info@accountsandlegal.co.uk. You can also get an instant accounting quote here.