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What are dividends and how are they taxed?

by | Apr 20, 2020 | Running a business

If you’re setting up a small business you’ll no longer be on someone else’s payroll, so you will need to understand how to extract money from your company. Unfortunately, it’s not a case of helping yourself to whatever’s in the bank.
You’ll need to work out what expenses you have to cover, what tax you owe and what profit your company has made. Then you can look at the most tax-efficient way to pay yourself.

For most small business owners, the best solution is a mixture of salary and dividend, whereby you take your tax-free personal allowance as salary and the rest of your income as a dividend. There are certain rules you have to abide by when calculating and taking dividends, however. Here we explain how dividends work.

What are dividends?

If your company has made a profit, it can distribute the money, known as ‘retained income’, to shareholders via dividend payments. In many small businesses, the owner will be the sole shareholder, but if you have other shareholders then dividends should be distributed according to the percentage of company shares owned by each shareholder.

Dividends are based on profits after business expenses and tax liabilities have been paid and are a tax-efficient way to pay yourself because, unlike a salary, they do not attract National Insurance Contributions (NICs).

It’s important to note that dividends can only be paid if the company has made a profit. This means you must account for tax liabilities and expenses before you take dividends out of the business. If you take money from your business as a dividend which exceeds the amount of profit it holds, the payments you receive are known as illegal dividends and could land you into trouble with HMRC.

From an accounting point of view, the over-payment of dividends is classed as an ‘overdrawn director’s loan’, this normally needs to be paid back to the company within 9 months of the year-end, or interest and additional tax may be due.
It’s important to note that you do not have to take all of your profit out of your business at the end of each financial year.

You can accumulate your retained profit and leave it in your business bank account for future use. This can be a helpful way to manage your income, and work tax efficiently, if you’re planning to take a break from work or if your available work reduces and you think you may earn less in the following financial year.

Illegal dividends

It’s important to note that dividends can only be paid if the company has made a profit. This means you must account for tax liabilities and expenses before you take dividends out of the business. If you take money from your business as a dividend which exceeds the amount of profit it holds, the payments you receive are known as illegal dividends and could land you into trouble with HMRC.

From an accounting point of view, the over-payment of dividends is classed as an ‘overdrawn director’s loan’, this normally needs to be paid back to the company within 9 months of the year-end, or interest and additional tax may be due.
It’s important to note that you do not have to take all of your profit out of your business at the end of each financial year.

You can accumulate your retained profit and leave it in your business bank account for future use. This can be a helpful way to manage your income, and work tax efficiently, if you’re planning to take a break from work or if your available work reduces and you think you may earn less in the following financial year.

Learn more about how to avoid illegal dividends.

How dividend tax is calculated?

Dividend tax is paid via the annual self-assessment tax return process so is included in the mix of your overall income from investments and interest. Each shareholder will benefit from a £2,000 dividend allowance, which means the first £2,000 is tax-free. The remaining dividend payments are taxed depending on which tax band they fall in above the personal allowance, the tax bands are as follows:

Tax Band 2018/19 2019/20 & 2020/21 Tax Rate
Basic £0 – £34,50 £0 – £37,500 7.5%
Higher £34,501 – £150,000 £37,501 – £150,000 32.5%
Additional £150,000+ £150,000+ 38.1%

Dividend tax example (2018/19)

The following example is based on a company shareholder who wishes to take a £50,000 dividend based on 2018/19 profits when they have been paid a salary of £11,850.

  • The first £11,850 of income is tax-free (the personal allowance).
  • The first £2,000 of dividends is tax-free (the dividend allowance).
  • The next £32,500 of dividends are taxed at the basic dividend rate (7.5%) = £2,437.50.
  • The final £15,500 of dividends are taxed at a higher dividend rate (32.5%) = £5,037.50.
  • Total dividend tax payable is £7,475.

Dividend tax example (2019/20 & 2020/21)

The following example is based on a company shareholder who wishes to take a £50,000 dividend based on 2019/20 profits when they have been paid a salary of £12,500.

  • The first £12,500 of income is tax-free (the personal allowance).
  • The first £2,000 of dividends is tax-free (the dividend allowance).
  • The next £35,500 of dividends are taxed at the basic dividend rate (7.5%) = £2,662.50.
  • The final £12,500 of dividends are taxed at a higher dividend rate (32.5%) = £4,062.50.
  • Total dividend tax payable is £6,725.

Unlike Corporation Tax, dividend tax should be made from your personal bank account by January 31st each year, the deadline for all self-assessment tax payments.

Updated dividend tax rates for 2020/21.

You can accumulate your retained profit and leave it in your business bank account for future use. This can be a helpful way to manage your income, and work tax efficiently, if you’re planning to take a break from work or if your available work reduces and you think you may earn less in the following financial year.

Administration of dividends

One of the key benefits of working for yourself is the ability to pay yourself whenever you like. Don’t forget, as long as your company has a profit, you can take a dividend. Here’s how it works:

  1. Your company must hold a board meeting to agree on the distribution of dividends. If you are the only shareholder, this is, of course, a formality.
  2. When you’re ready to take a dividend, you simply prepare a ‘dividend voucher’, a basic record which details:
  • The date the dividend is paid.
  • Your company name.
  • The name and address of the recipient.
  • The total number of shares owned by the shareholder.
  • The total dividend payable to the shareholder.
  • The director’s signature.

 

Find out more

When you work with Clever Accounts, we’ll help you work out and administer your small business income, including dividend payments. It’s a straightforward, hassle-free service which means we take care of all the paperwork leaving you free to concentrate on running your small business. Our accounting software will generate a dividend voucher for you. It will be held within the online portal so that you can access it when required (ie. in the unlikely event of an HMRC investigation).

Choose the best service plan for you, or get in touch to find out more.


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