Dividends are a key part of limited companies, so it’s important that contractors are aware of what they are, how they work and how much tax they have to pay on them. As contractor accountants, we work with many limited company owners and have helped them learn more about dividends.
For instance, did you know that if you own a limited company, drawing dividends can improve your overall tax efficiency? This matter can be complex, so we’re covering it in this article and starting with the basics.
What Are Dividends?
Firstly, you should know what dividends actually are. In essence, limited company profits (after tax) can be distributed to shareholders as dividends, no matter the size of the company.
This means you may have the opportunity to pay yourself a salary and draw dividends, which can be more tax-efficient and maximise your take-home pay as well. Dividends are not drawn as payment for services, so keep in mind that you can only take them if there’s profit.
If you’re operating through a limited company and draw a salary, you will pay income tax and National Insurance contributions on it. When it comes to dividends, however, neither you nor the company has to pay National Insurance.
How do Dividends Work in the UK?
Drawing dividends is a simple process. In many cases, a spouse can also own shares in the company – because dividends are paid out according to the amount of shares the shareholders own, if your company only has two shareholders (yourself and a spouse for example), then you each own half of the company. If you declare £20,000 in dividends, then both of you would receive £10,000.
Before paying out dividends, you must hold a directors’ meeting to declare the dividend and keep minutes of this meeting, even if you’re the only director.
Every time you make a dividend payment, you must create a dividend voucher that displays the date, company name, names of the shareholders receiving a dividend, the amount paid and the signature of the director. Shareholders get a copy of the voucher and you need to keep a copy for the company’s records as well.
Are Dividends Taxed?
The short answer is yes, although they are not taxed like other income is. You’ll be glad to know that your limited company will not have to pay tax on dividend payments; however, shareholders will have to pay income tax on anything over £2,000.
In the tax year of 2020/21, the tax thresholds for dividend payments are the following:
0% – up to £2,000
Basic rate of 7.5% – £2,000 to £37,500
Higher rate of 32.5% – £37,501 to £150,000
Additional rate of 38.1% – over £150,000
The dividend allowance can be combined with your £12,500 personal allowance, so this can raise the amount of tax-free dividends you can withdraw. This makes drawing dividends more tax-efficient than just paying yourself a wage in most cases.
As an example, you can pay yourself a salary of £8,000 and withdraw £30,000 in dividends, since you only used £8,000 of your personal allowance, the remaining £4,500 can be added to the £2,000 tax free dividend allowance. You won’t have to pay tax on the first £6,500 of your dividends, then. The rest of your dividends will be taxed at a rate of 7.5%, which means you only have to pay £1,762.50 in income tax.
For most contractors, the best option is to take a low salary, which is taxes with PAYE and National Insurance contributions, and boost your wages with dividends.
When Can You Draw Dividends?
Knowing when you can draw dividends is also important, as you can only do it when there are enough retained profits. Technically, there is no limit to the amount of times you can take dividends as long as there’s profit in the company.
It is your responsibility as the company’s director to pay dividends and to know how much to distribute to shareholders. If there is not enough retained profits in the company and you still choose to draw dividends, these may be considered illegal (or a director’s loan). You may come under investigation for this as well, as HMRC will want to make sure everything is in order.
You don’t have to withdraw all dividends if you don’t want to and can leave some in the business for tax purposes. If you’re unsure how to do this, an accountant can guide you through the process.
Dividends and IR35
IR35 is a subject that continues to worry contractors who offer their services via their limited company.
Whether or not you’re caught within IR35 will determine the way you handle dividends. For example, if you’re within it during a specific contract, you won’t be able to go for the ‘low salary and dividends’ option, as all payments should be done via salary.
You should withdraw the majority of your income in the form of a ‘deemed salary’ and will have to pay PAYE income tax and National Insurance contributions on it. The tax rates are the same as those of permanent employees.
How Much Can You Actually Distribute?
To figure this out, you have to deduct company expenses first, which includes salaries and taxes, as well as any other costs you may incur. Then, you have to pay corporation tax on the remaining value (at a rate of 19% for the current tax year).
The rest is considered ‘retained profit’ that you can distribute to shareholders, according to the number of shares they own.
FreeAgent accounting software can help you with this, as it allows you to see how much you can take out and distribute in dividends. If you have any doubts or concerns, talking to an accountant can put your mind at ease. As limited company accountants, we are on hand to help you figure this out, so don’t hesitate to get in touch to learn more.
This bookkeeping tool can be accessed from anywhere and at any time and provides real-time information that you can use to make quick – and accurate – business decisions.
At Gorilla Accounting, we understand how the world of finance and accounting can be time-consuming for those looking to build or grow their business, so we can handle it all instead. Our clients even get a same-day reply if they contact us before 3pm.
Contact us today on 0330 041 6094 to learn more about how we can help, be it assisting you with the matter of dividends or helping you set up your own limited company.