What are dividends & how do you pay them?

What are dividends and how do you pay them?

Dividends are a key element of the strategy for setting up a company, as they allow shareholders to receive a distribution of profits out of the company in a tax efficient way.

Below, we take a closer look at how dividends work, how you pay them, their tax implications and whether there is any risk involved in accepting them over a salary. 

What are dividends: understanding the basics

Dividends are payments made by a company to its shareholders. Provided you possess the appropriate shares and the company in which you’ve invested is in good financial standing, you may potentially receive these payments periodically.

Typically, companies allocate a portion of their earnings to shareholders when they have surplus cash after covering their expenses and company tax obligations. For instance, if you own three-quarters of the company’s shares you’ll receive 75% of each dividend.

This is a widespread practice, especially among financially stable companies that generate profits and don’t require significant reinvestment in their operations.

Owner Managed Businesses (OMBs) benefit from a multitude of choices for their investments return, shareholders receive an appealing loyalty reward that when accumulated over several years, can enhance their overall returns.

Who are dividends for?

Dividends are paid to the shareholders of a company as a way to distribute a portion of the company’s profits. When a company declares dividends, it effectively shares its profits with its shareholders as a reward for their ownership stake. This distribution of earnings serves as a financial incentive for shareholders, providing them with a steady income stream in the form of dividend payments.

How do you pay a dividend?

Dividends can be distributed regularly, most often semi-annually, or as one-time payments. Usually, however, they are declared within the fiscal year, with an interim dividend announcement and a final dividend declaration at year-end.

Sometimes, a company may issue a special dividend, usually following a substantial windfall, like proceeds from asset sales. That said, paying a dividend revolves around several key dates within a company:

• Board Decision: The company’s board of directors first decides whether to pay a dividend, the amount per share, and the dividend declaration date.
• Ex-Dividend Date: This date, usually two business days before the record date, is critical. Shares bought on or after the ex-dividend date are not eligible for the upcoming dividend.
• Record Date: The company sets a record date, typically a few days after the board’s decision. Shareholders on record as of this date are eligible to receive the dividend.
• Payment Date: On the predetermined declared payment date, the company distributes dividends to eligible shareholders and this distribution should be clearly recorded in the company’s financial statements.

Paying dividends is a structured process that involves careful consideration of financial health, regulatory requirements and shareholder communication.

It’s important to note that dividends can only be paid from a company’s retained profits, meaning that the company must have accumulated sufficient earnings.

Maintaining up-to-date and accurate financial records is vital to ensuring that a business can assess the profits available for distribution. Directors should also be aware that retained profits are business profits which have been subjected to corporation tax for the period. If dividends are declared based on available cash, without sound consideration of the tax obligations, businesses can face regulatory and compliance issues.

How much tax do you pay on dividends?

The tax-free dividend allowance for the 2024/25 fiscal year has been reduced by half, going from £1000 in the previous year to £500 and staying at this rate for the foreseeable future. This implies that individuals receiving more than £500 in dividend income will owe taxes on the surplus, at their respective marginal tax rates.

Once an individual’s dividend income reaches the dividend allowance threshold, the tax rate applied to this income hinges on their total income for the particular tax year. The dividend tax rates for 2024/25 are as follows:

One key consideration is that when assessing your overall income to determine your tax bracket, dividend income is taxed as the highest part of a person’s total income. For instance, if your income comprises salary, bank interest and dividends, the dividend income will be subject to the highest tax brackets, as it’s consistently the last to be factored into the tax calculation.

That said, National Insurance contributions do not apply to dividend payments. This is one of the key reasons many directors who are also shareholders prefer to combine a modest salary complemented with dividends, creating a more tax-efficient income strategy.  Unlike salaries, dividends are not taxed at source, making it is essential to keep accurate records of all distributions received. These must be included on the individual’s Self-Assessment tax return.

If it is the first year of receiving dividends and you do not normally file a tax return, HMRC must be notified of the additional income after the end of the tax year (5 April) but before the 5 October following the tax year. This ensures all necessary tax obligations are met efficiently and on time.

Are there any restrictions as to when you should and should not take dividends?

Your ability to take dividends is reliant upon retained profits. As stated, these profits are reduced by a business’s corporation tax liability. This means that whilst being the owner of a limited company comes with significant benefits, an awareness of the restrictions of dividends is crucial. 

With this in mind, being the shareholder of a limited company still offers significant flexibility, allowing the shareholder to determine the timing and amount of dividend payments. In fact, as the shareholder you have the freedom to distribute dividends at your discretion, provided there are sufficient profits within the company.

This ability to make choices regarding the frequency and size of dividends is a valuable aspect of trading through a limited company and can be instrumental in effective tax planning.

Working closely with your accountant and your company’s accounting or tax  services will also allow you to optimise the advantages associated with rewarding yourself through dividends. Importantly, you retain control over the timing of fund withdrawals from the business, allowing for greater tax efficiency. 

Is it better to take dividends or a salary?

The choice between taking dividends or a salary depends on individual circumstances. Salaries are subject to income tax and National Insurance Contributions (NICs), while dividends are typically subject to lower tax rates.

However, salary payments can contribute to entitlements like state pension and statutory benefits. Dividends, however, are often more tax-efficient for those with higher earnings, but salaries may be preferable for those who need consistent income or wish to build NIC-based entitlements.

It’s crucial to consult with a tax advisor or accountant to determine the best approach, as each situation is unique and depends on factors like income level, financial goals and tax regulations.

Understanding the nuances of dividends is essential for effective financial planning. Whether you opt for dividends or salaries, it’s a decision that should align with your specific financial goals and circumstances.

Get in Touch

For personalised guidance on optimising your dividend strategy, tax planning, and overall accounting solutions, please consult the experts at Rayner Essex. Our experienced team is here to help you make informed choices that can lead to greater financial growth and success.

Disclaimer: Please note that this document is not intended to give specific technical advice and should not be construed as doing so.  It is designed to alert clients to some of the issues and not intended to give exhaustive coverage of the topic.  Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.