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In a Limited Company, dividends refer to the share of profit, which is distributed to the Company's shareholders. Dividends are calculated on the profit left after deducting all the expenses and taxes of the Company. In this article of "Path of Education for New Contractors", we shed more light on Limited Company Dividends.
It is important to note that a Limited Company does not have to share its entire profit as dividends. A Company can choose to share part of its profit as dividends and set aside the rest of the profit for future investments. Frequently, a Company may make a profit, but will want to save some funds for the future, so it may not distribute any dividends.
Dividends are calculated on the basis of a Companys shareholding structure. i.e. Shareholders owning 25% of shares will get 25% of the dividends.
Example 1: Let's say a Limited Company has a profit of £2,000, and it decides to distribute £1,000 in the form of dividends. The Company has three shareholders, one with 50% share, and two with 25% shares each. In such a scenario, the shareholder with 50% will get £500 and the ones with 25% each will get £250 each.
Dividends are of two types. If the dividend is declared during the financial year, it is called as an 'interim dividend'. If the dividend is declared after the completion of the financial year, it is called as a 'final dividend'.
For declaring dividends, a Company is legally required to call a meeting of all Board of Directors. The Company should maintain minutes of all such meetings in its records. Every shareholder should be provided with a dividend voucher, which can either be in electronic or paper format. Both the minutes and the vouchers are essential for records, especially with consideration to HMRC investigations.
Even if the Company is a one-man Limited Company, the necessary procedures should be followed. For example, you should issue dividend vouchers to yourself even if you are the only shareholder.
Directors can withdraw money from their Company in three ways:
Of all the three methods, dividends are the most tax-efficient way of withdrawing money. Also, you don't have to pay National Insurance on dividends.
Dividends are an additional source of income to the Directors and shareholders and personal income tax must be paid on any dividends received. However, there is a 10% dividend tax credit available on all dividend income. This is because before distributing dividends, Companies have already paid a Corporation tax of 20% on the profits. Dividend tax credit is to ensure the same profit is not taxed twice.
For the calculation of dividend tax credit, the dividend received by the shareholder is referred to as the "net dividend." You should divide the net dividend by 9 to get the amount of tax credit. This tax credit amount should be added to the net dividend to get a "gross dividend."
Example 2: Your Company has given you a dividend of £9,000 for a year. This is a "net dividend." If you divide the net dividend by 9, you get the tax credit of £1,000. You need to add the tax credit (£1,000) to the net dividend (£9,000) and get a gross dividend amount of £10,000. For the calculation of personal tax, you need to use the gross dividend amount and not the net dividend amount.
Your income tax liability will depend on your total income, which will include salaries, bank interest, rent from properties, etc. After adding all of your income, you should deduct the personal tax allowance available to all taxpayers. Finally, you should add the net dividend amount to your income, and calculate taxes as per rates given below.
|Dividend income less than or equal to £31,865||10%|
|Dividend over £31,865 and up to £150,000||32.5%|
|Dividend income above £150,000||37.5%|
Example 3: Your annual income is £60,000, which includes £20,000 of salary and £40,000 of dividends. First, you need to deduct the personal allowance of £10,000 from this amount. Next, you should calculate the gross dividend using the method given above. In this scenario, after adding a tax credit of £4,444 (£40,000/9), the gross dividend works out to £44,444. So, your total taxable income is £54,444. Out of this income, you will have to pay 10% tax on the first £31,865, which works out to £3186.5. On the remaining £22,579 (£54,444 - £31,865) you need to pay a tax of £7,339 (£22,579 x 32.5%). So the total tax payable is around £10,524.
As long as you have profits available for distribution, there's no limit on the number of times you can distribute dividends. Also, you can distribute dividends at any time of the year. The flexibility in the timing of declaring dividends can help in tax planning.
For example, you may work very hard in a particular year, so that you can take a break next year (for travelling, education, family breaks, etc.) You can take less dividend in the first year and declare a major portion of the profit in the next year (where you may have less income due to the break).
At times, Limited Company Directors make a mistake and pay higher dividend than the available profit allows. (E.g. Director pays a dividend using the balance available showing in the bank account, but has not accounted for expenses). When accounts are prepared at the end of the year, you may realise that you have paid more dividends than you profits will cover. Such dividends are termed as illegal dividends or Ultra Vires. To avoid paying illegal dividends, Directors should check the accounts and the profit to-date before declaring a dividend.
Illegal dividends are not a serious offence and can be corrected by repaying the excess amount back to the Company. However, this is poor business management and should be avoided.
As you know, all the shareholders have rights on the declared dividends. At times, some shareholders may not take a dividend, deciding to 'waive' their dividend rights for the benefit of other shareholders. Note that dividend waiver is valid only for commercial reasons. For example, the Company may want to set aside funds for future investments.
A Dividend waiver is considered to be illegal if it is done with the intention of avoiding paying tax. We have listed some examples where dividend waiver is considered as done for non-commercial reasons.
Example 4: A husband has a 60% share in a Limited Company, and the remaining 40% is owned by the wife. The husband is drawing a salary from the business and his income is in a higher tax band, whilst the wife does not have any source of income. If husband waives off his right to dividends to take advantage of the wifes lower tax band, this waiver will be considered as illegal.
Such settlements are likely to be questioned by the HM's Revenues and Customs (HMRC).
Dividends are an important part of a Limited Company, so proper care should be taken while announcing and paying dividends. Similarly, you need to be careful about the accounting and legal implications of dividends.
If you engage a professional accounting firm, your accounting and profit records will be up-to-date and you will avoid declaring any illegal dividends. You will also get specialist advice on how to deal with dividend waivers. Utilising the expertise of Tempo Limited Company or Limited Company Gold services should be considered, as they cover all the accounting and taxation needs of Limited Companies.
You may also find the following contractor calculators useful for your salary and tax calculations.