With several different ways to take money out of a limited company, one question many directors have is how they can pay themselves in the most tax-efficient way. Paying year-end dividends is one option available to company directors, but is this a payment strategy they’d be wise to take?
In this guide, we’re going to explore whether drawing down dividends is the best way to take an income from your limited company, discuss the dividend tax you will have to pay and look at the potential risks of this payment type.
What is a Dividend?
A dividend is a form of payment a company can make to its shareholders if it has made a profit. This is the money remaining after all business expenses, liabilities and outstanding taxes have been paid. Dividends can be paid from profits for the current year or retained profits from previous years. Any excess profit not distributed in the form of dividends will remain in the company’s bank account.
Dividends are usually paid to all shareholders according to the proportion of the shares they own in the business. For example, if a shareholder owns a quarter of the company’s shares, they will receive 25 percent of each dividend distribution.
Despite dividend tax hikes in the last few years, taking cash out of a limited company via a dividend payment is still the most tax-efficient way to pay yourself as a director. That’s because dividends are not subject to National Insurance contributions (NICs) and dividends are taxed at lower rates than income from a salary.
How do I pay Myself a Dividend?
To pay yourself a dividend as a company director, the first step is to calculate the available profit in the limited company (current profit + retained profit). That is the maximum amount which is available for a dividend payment. You should also consider ongoing liabilities such as loans and lease deals to ensure you have sufficient money in the business to handle those payments.
Once you’ve decided how much the dividend will be, you must then hold a directors’ meeting to declare the dividend. You must take minutes of the meeting even if you are only the director. This should include details such as the date of the dividend payment and the amount. Limited companies can issue dividends at the end of the financial year or at various points throughout the year.
The next step is to create a dividend voucher. That should include the following information:
- The company name
- The name of the shareholders receiving a dividend payment
- The dividend amount
- The date the dividend will be paid
Once the dividend voucher has been created, you must give a copy to all recipients of the dividend and keep one for your company records. The dividend can then be paid.
How are Dividend Payments Taxed?
Your company does not have to pay any tax on the dividend payments it issues, but the shareholders may have to pay tax on the dividends they receive. This will depend on the amount they receive and their personal circumstances. This will be paid through their annual self-assessment tax return.
All shareholders have a £2,000 dividend allowance from 6 April 2022 to 5 April 2023, which means the first £2,000 of any dividend payment is not taxable.
Everyone also has a personal allowance of £12,500 before any income tax must be paid. The following tax rates will apply to dividend payments after the £12,500 personal allowance has been used:
|Dividend Tax Rate||From||To|
Salary vs. Dividends
Most company directors take a small salary that does not exceed their personal income allowance of £12,500. Income above this point would be taxed at the basic rate of 20%, rising to 45% for additional rate payers. They then take the rest of their money out of the company in dividends.
Dividends & Salary
If we look at the example of a director taking £50,000 out of a limited company in a tax-efficient combination of salary and dividends, it would look like this:
- The £12,500 salary is tax free due to the personal allowance
- The first £2,000 of dividends are tax-free due to the dividend allowance
- The next £35,000 of dividends are taxed at the basic dividend rate of 8.75%
That means the total tax payable for the year is just £2,662.50, leaving an income of £44,540.50.
If we look at the amount of tax the same director would pay if they took the £50,000 out of the limited company as a salary:
- The first £12,500 of income is tax-free due to the personal allowance
- The next £37,500 would be taxed at the basic income tax rate of 20% = £7,500
- They would also have to pay National Insurance contributions of £5,316
The means the total tax and NICs payable for the year is £12,816, leaving an income of £37,184.00
When is the Best Time to Take a Dividend?
As the owner of a limited company, you are free to take a dividend payment whenever you like and choose the amount you want to take, as long as it does not exceed the profit the company has made. However, it’s usually advised that dividends are processed on a monthly, quarterly or annual basis to keep record-keeping simple. It’s also worth keeping dividend and salary payments separate to create a clear audit trail.
What are the Considerations Associated with Dividend Payments?
Given the income projections above, the benefits of taking a small salary and dividends as opposed to a large salary are plain to see. However, there are also a number of considerations and potential risks associated with this strategy that you should be aware of.
- Pension contributions – Paying yourself a salary increases the level of contributions that can be paid into a personal pension. If you want to take the bulk of your income as a dividend and make a pension contribution, you should consider setting up a company pension.
- Fair rates of pay – All shareholders are entitled to a dividend at a fixed rate per share. However, not all shareholders do the same amount of work for the company. It is possible to create different classes of shares to ensure that shareholders who do not work full-time for the company receive reduced dividend payments, but that will add to the complexity.
- Illegal dividends – Dividends can only be paid from profits, while salaries can be paid even when the company is making a loss. Dividends are deemed to be illegal (known as ultra vires dividends) when there are insufficient profits in the company to cover the amount paid. Dividends may also be deemed illegal where a dividend voucher has not been completed and authorisation for the dividend has not been provided in the form of board meeting minutes.
- Corporation tax deductions – Paying a salary can reduce the company’s corporation tax liability. Paying a dividend will not.
The Risks Associated with Illegal Dividends
If your company does not have sufficient current or retained profits to cover the full dividend payment, it will be regarded as ‘ultra vires’, which means ‘beyond the powers’, and it can expose the directors to the risk of personal liability issues. That means, if the company is struggling, the only money you earn could be the small salary you pay yourself.
If you take a dividend payment the company cannot afford, you could end up with a substantial overdrawn director’s loan account at the end of the year. This is money you have taken out of the company that must be repaid within nine months of the end of the corporation tax accounting period. Fail to do so and HMRC will regard the overdrawn director’s loan account as income, leaving you with a hefty income tax and National Insurance bill to pay.
Worse still, if the company enters a formal insolvency procedure such as administration, a company voluntary arrangement (CVA), creditor’s voluntary liquidation (CVL) or compulsory liquidation, you will have to repay the money for the benefit of the company’s creditors. Potentially, you could even face accusations of wrongful trading and be banned from operating as a company director for up to 15 years.
Still unsure about the best way to take money out of a limited company? Perhaps you’re concerned that a dividend payment you’ve made is illegal, or that you’ve created an overdrawn director’s loan account that you’re unable to repay? Whatever your situation, get in touch with our team for a free, no-obligation discussion to help you find the best way forward.