What are dividends?
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Dividends are probably one of the most common and important areas we are asked about by contractors working through a limited company.
Simply put, a dividend is a payment made to shareholders of the company from the company profits – after corporation tax. It is normally the most tax-efficient way of taking money from the company, which is why we usually advise our clients to pay themselves (and other shareholders) a low salary, with high dividends.
What is a dividend?
When a limited company makes a profit, it pays corporation tax alongside business expenses, liabilities and other applicable taxes such as VAT. The money left over after all these payments have been made is available to pay to shareholders – anybody who owns at least one share of a company’s stock – by way of a dividend payment.
The leftover profit itself is not called a dividend – rather, the term ‘dividend’ refers to the actual payment of the leftover profit from the company to a shareholder. Consider the word ‘salary’, which more people are familiar with. It is the same sort of idea in that the money going to an employee is remunerated as a salary payment.
So what is the difference between a salary payment and a dividend payment?
Let’s start with understanding the differences between salaries and dividends, and how either forms of payment to shareholders are taxed. The rates of income tax differ between dividends and salaries – this in itself is pretty complex.
Tax and National Insurance due on salaries is collected through the payroll system, which would normally be monthly. Income tax due on dividends for higher rate tax payers is usually collected through the self-assessment tax return system, which is nine months following the end of the tax year.
Salaries paid from your company will normally be classed as an allowable expense – i.e. the amount of the salary plus the employer’s National Insurance will reduce the profits of the company, and in turn reduce the amount of Corporation Tax payable by the company.
Dividends are paid to shareholders from the profits of the company after Corporation Tax has been taken into account.
A salary totalling more than your personal tax allowance (£12,500 for the next tax year commencing 6 April 2019) is taxable. This means that you can take home a salary of up to £12,500 per year without having to pay any tax. Once you start earning a salary of £12,501 or more, you will have to start paying the basic tax rate of 20%.
Dividend payments are taxed at lower rates, as they are not considered salary payments, but rather the sharing of a company’s profits between its shareholders. A company can pay dividends to its shareholders at any time while it is in profit – when a company is not in profit, it is unable to declare dividends. If it does, this is illegal and causes a mountain of issues.
A company’s profits are calculated from the leftover monies after corporation tax has been paid, alongside business expenses, liabilities and other applicable taxes such as VAT.
For the tax year 2019-2020, contractors (and all other taxpayers) have a tax-free Dividend Allowance of £2,000 after the personal allowance of £12,500 is used. For dividends between £2,001 and £37,500, taxpayers at the basic rate pay 7.5% tax, higher rate taxpayers pay 32.5% and additional rate taxpayers pay 38.1%. The rates increase at £37,501, and increase yet again at £150,001.
Salaries are generally subject to National Insurance for both the individual (Employee’s NI) and the company (Employer’s NI). Dividends are not subject to National Insurance. Further, salaries are classed as ‘earnings’ for tax relief on Pension Contributions whereas dividends are not.
So a low salary but high dividend payments mean I can pay less tax than if I just pay myself all my company’s profit as a salary?
Correct – when worked out properly! We can help you figure out what salary to pay yourself alongside dividend payments in order for you to pay the least amount of tax possible (while still meeting all the legal tax requirements!).
Where does IR35 fit into all this?
One of the first and possibly the most important thing we do with contractor clients is help establish whether they fall inside or outside of the IR35 legislation. IR35 is an extremely complex subject in itself and we, as contracting and IR35 specialists, can help you determine your status.
Having established your IR35 status the next step should be for us to understand your personal financial requirements, such as whether you had employment income prior to starting your company in the current tax year, the minimum income required by you from the company to ensure you receive sufficient funds to pay your day-to-day living expenses, whether you have income from other sources e.g. rental properties or investment income, what your short and long term intentions are i.e. whether you need a lot of income immediately (e.g. to pay off debts) or whether your circumstances more flexible to enable you to time the distributions from your company in a more tax-efficient manner.
Based on the answers to these and other questions we can carry out strategic bespoke tax planning and recommend the most tax-efficient way for you to take income from your company.
As you can see there is no simple one-size-fits-all formula, and we highly recommend taking tailored advice before planning your salary and dividend payments from your limited company. Get in touch – we are happy to help!
Nicola J Sorrell -
Founder | Xero Champion | IR35 Expert
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