The retained profits generated by UK companies of all sizes can be distributed to shareholders. For professional workers (such as contractors, consultants, and freelancers), dividends make up the bulk of income drawn down from small limited companies.
This article details what dividends are, and how they are taxed. You can also read our guide to the old dividend tax system pre-April 6th 2016.
What are dividends?
If a limited company has made a profit, it is free to distribute these funds to its shareholders. This is the money the company has remaining after paying all business expenses and liabilities, plus any outstanding taxes (such as Corporation Tax and VAT).
This ‘retained profit’ may have been accumulated over a period of time, and any excess profits not distributed as dividends simply remain in the company’s bank account.
Working via a limited company is a tax-efficient way to operate, as National Insurance Contributions (NICs) are not payable on company dividends, whereas they are payable on salaried income.
Dividends must be distributed according to the percentage of company shares owned by each shareholder, i.e. if you own half the company’s shares, you will receive 50% of each dividend distribution.
How to calculate the tax payable on dividends
The dividend taxation system was changed on 6th April 2016. The old system, which involved ‘grossing up’ net dividends via tax credits was replaced by a system of fixed tax rates for the 2016/17 tax year onwards.
You need to let HMRC know how much dividend income you have received via the annual self-assessment process.
Dividend income is taxed as follows:
|Tax Band||2018/19 Income||2019/20 Income||Tax Rate|
|Basic||£0 – £34,500||£0 – £37,500||7.5%|
|Higher||£34,501 – £150,000||£37,001 – £150,000||32.5%|
|Additional||£150,000 +||£150,000 +||38.1%|
A £2,000 dividend allowance is also provided, which means the first £2,000 of dividends is not taxable. However, this allowance does not reduce the total income figure upon which you are taxed.
Dividends are taxed after your other income sources have already been taxed, e.g. your salary and other relevant earnings (from savings or investments). So, your dividends will fall into one or more of the tax bands listed above, after your personal allowance and other income sources have been added together.
Dividend tax example (2018/19)
Here are the steps to take to calculate the dividend tax owed during the 2018/19 tax year – for a company owner taking an £11,850 salary, and £50,000 in dividends.
- 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 the higher dividend rate (32.5%) = £5,037.50
- In this example, the total dividend tax payable is £7,475
Dividend tax example (2019/20)
Here are the steps to take to calculate the dividend tax owed during the 2019/20 tax year – for a company owner taking a £12,500 salary, and £50,000 in dividends.
- 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 the higher dividend rate (32.5%) = £4,062.50
- In this example, the total dividend tax payable is £6,725
Dividend tax – online calculators
Use our dividend tax calculators to calculate the additional tax you have to pay at self-assessment time.
Dividends – getting the paperwork right
To comply with the law, all companies must hold a board meeting to agree on a dividend declaration and must record the meeting minutes in the company’s records. Of course, in practice, with many companies being run by sole directors, this is more of a paperwork exercise than anything.
Alongside the company paperwork, the directors must provide each shareholder with a dividend voucher. An electronic voucher (i.e. one attached via email, or automatically generated by an accounting software package) is perfectly acceptable these days if previously agreed by shareholders. Otherwise, the company should post a paper voucher to each shareholder.
The voucher should detail:
- The date
- The 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 (for dividends 6th April 2016 onwards)
- Director’s signature
It is essential that you maintain the correct paperwork – including paper records of board meeting minutes, as you may need to produce them in the unlikely event that you are selected for an HMRC investigation.
View our example dividend paperwork templates.
There are no rules which determine how often you distribute dividends, however many accountants suggest processing dividend payments on a quarterly basis, for easier record keeping.
The most important thing you must remember is that all dividend distributions must be legal (i.e. there is sufficient retained profit in the company to cover them). Otherwise, they will be classed as illegal, or ‘ultra vires’, and could result in HMRC penalties and further action in some cases.
Unlike traditional employees, limited company owners are in the fortunate position that they can determine the timing of dividend payments, as well as the amounts to be distributed.
This can help in tax planning. For example, if you are working hard during the current tax year, with a view to taking a ‘career break’ next year, you would be wise to delay distributing some of your profits until the year when you will be earning less – and pay less higher rate tax by splitting the distribution over two separate tax years.
You may also benefit by splitting ownership of your company with a spouse, particularly if they don’t have any other source of income (or modest earnings). As a couple, you can take advantage of the non-working partner’s tax allowance, and pay less higher rate tax.
What is a dividend waiver?
It is possible for one or more shareholders to waive their rights to receive a dividend, so a dividend is distributed to some, and not all shareholders. Care should be used when considering the use of a dividend waiver, as if this is not done for genuine commercial reasons (such as ensuring that the company retains sufficient capital after the distribution), you may attract the attention of HMRC. Read our guide to dividend waivers, and how they work.
IR35 and dividends
If you enter into contracts to provide professional services to clients via your limited company (typically as an IT contractor), you may be aware of a piece of tax legislation called IR35.
If your contract work is caught by IR35, you will have to draw down the bulk of your company’s income in the form of a ‘deemed salary’, after allowing for a fixed 5% ‘administration allowance’ for the costs of running the company. Please note that if your contract is with a public sector organisation, you can no longer claim this allowance.
You will have to pay full PAYE income tax and NICs on this deemed salary – at the same rates paid by permanent employees.
So, if you do work as a limited company contractor, you should make IR35 compliance a key priority, as the financial consequences should you be caught are significant.
- We also recommend you sign up to receive email updates on any future limited company tax changes, via our in-house newsletter.
- Find out the most tax-efficient way to pay yourself as a limited company owner, in terms of salary + dividends.
- Find out more about the different taxes a typical contractor has to pay (either as a limited company, or an umbrella employee).
- Please use this article as a guide only, and make sure you choose a specialist contractor accountant if you have any questions about how dividends work, dividend timing, and how best to set up your company’s share capital.