Stuart Crook FCA, explains how dividends work and their treatment for the purposes of taxation.
You may have just opened your business and incorporated, or perhaps you've changed structure to a limited company. Whatever your circumstances, you'll likely have heard of dividends in business circles but may not yet know much about them. So, if you're operating through a limited company, this post will help you by explaining the concept of dividends, when they can be distributed, and how they are taxed.
A dividend is a payment to shareholders from the profits made by a limited company. This means a company can therefore only make a dividend payment if it's profitable. Any pay out therefore can't be greater than the profits generated in the current and previous financial years.
Profit refers to the money a company has remaining after paying all its tax liabilities (such as VAT and Corporation Tax), and expenses (think wages and rent for premises). It's illegal to pay out a dividend if the company doesn't have sufficient profit after tax to cover the amount of dividends. Of note, unlike salaries, dividend payments can't be classified as a business expense.
Profit can be accumulated over many years in a limited company and this is known as "retained profit". Consequently directors don't necessarily have to distribute profits for the end of the company's accounting year as dividends. Instead the profits can be kept in the business and then made available for distribution at some point in the future.
Typically, shareholders will draw the bulk of their earnings in the form of dividends as, depending on their personal financial circumstances, this could be the most tax efficient way of extracting money out of the business.
How to issue a dividend
To issue a dividend you'll need to hold a meeting of your directors and firstly, declare a dividend. This meeting has to be minuted and a record retained of it for legal reasons. These are included in the year end approval documents when your accounts are signed.
Each dividend payment you make has to be issued as a dividend voucher. All recipients of dividends need to be given a copy of the voucher and a copy must be kept for your accounting records. The voucher must contain:
Your company name
The names of all your shareholders being paid dividends
The date of when your dividend is paid out
The cash amount of your dividend
Dividends are recorded in your accounts when they are set to be paid out. The payment amounts are usually calculated by the percentage of company shares that are owned by each individual shareholder. If you have 4 shareholders with an equal split of all shares, then each of them will receive 25% of all dividends distributed. There are exceptions to this rule, more on that later in this post.
Also, a word of warning, any dividends not properly recorded could be seen as directors' loan account and the result could be additional taxes for the company and individual(s) in question.
How much can you take in dividends? What to be aware of
Often the assumption is dividends can be paid out of any cash in the business bank account. However, that's not necessarily the case. A limited company can distribute the whole of its accumulated realised profits, less its accumulated realised losses.
The reality however, is that unrealised losses also need to be factored in. You can't have dividend payments based on accounts that show profits, if subsequent losses then eliminate those earnings. Directors are personally liable to to the company should an unlawful dividend payment be deemed to have taken place.
The Companies Act stipulates that shareholders are liable to repay a dividend distribution, if at the time of the payment, they knew, or had potential knowledge, that it could be illegal.
You also need to review the company's Memorandum of Articles which may include statements that restrict dividends in certain circumstances. Also, different types and classes of shares may exist, and these can impact on entitlement to dividends and voting rights. Details of the company’s shares and the rights attached to them are covered in the statement of capital.
The timing of when to pay dividends
Typically, dividends are paid when your year end figures have been agreed and there is sufficient cash available in the business. These are known as final dividends. The reality however, is you can pay yourself dividends whenever you want, provided the money is available in the business. If it's a payment that's not at your year end, then these are known as interim dividends.
How and when to make a dividend payment can have personal tax implications dependent on when certain tax changes are introduced. An example of this is covered in the section below. It is therefore wise to seek professional advice regarding profit extraction in relation to potential, estimated tax liabilities.
How much are dividends taxed?
You don't need to pay tax on the first £2,000 of dividend income that you receive, this is know as the tax-free dividend allowance. Above this, your level of tax exposure is based upon which tax band you fall in, and that's dependent on your other level of income. This is referred to as your marginal tax rate.
What this means is you get the £2,000 dividend allowance and your other income qualifies you for the personal allowance for income tax. For the 2021/22 tax year this is £12,570 meaning you can earn potentially £14,570 income before having to pay tax. The dividend tax rate per each income tax band is stated in the table below.
Income tax band
Dividend tax rate 2021/22
Dividend tax rate 2022/23
(income of £12,570 - £50,270)
(£50,271 - 150,000)
For the 2022/23 tax year, the dividend tax rate will be increased by 1.25 percentage points as part of the the government's health and social care levy announcements.
How to pay the tax on dividends?
If you earn income above the allowance but under £10,000 then you'll need to inform HMRC. The tax can then be paid either by:
Filling out a self-assessment tax return or;
Getting HMRC to adjust your tax code thereby ensuring it is taken from your salary or pension
If you earn income above £10,000 in dividends then you'll need to fill in and complete a tax return. You have to declare this income in the dividends section of the form.
Please be aware that information provided by this blog is subject to regular legal and regulatory change. We recommend that you do not take any information held within our website or guides (eBooks) as a definitive guide to the law on the relevant matter being discussed. We suggest your course of action should be to seek legal or professional advice where necessary rather than relying on the content supplied by the author(s) of this blog.