Dividends: What are they and how are they taxed?
Both dividend tax and National Insurance will increase by 1.25% from April 2022. Both tax increases will impact small business owners who take profits from their business and hire staff on payroll. Here we look at how to use dividends tax efficiently as a director of a limited company.
Recap: what are dividends?
A dividend payment from your limited company is one way to extract profits from your business. You have the option to use dividends if your business is profitable and the amount of dividends you can take out is based on profits after paying after corporation tax.
Business owners can pay themselves through a salary or dividend, or a combination of the two. Profits extracted from the company can be spent freely and as you wish.
Why pat yourself in dividends?
Generally speaking it is beneficial for you to extract profits from your limited company via dividends, as historically dividends attract one of the lowest rates of tax.
Furthermore, every UK taxpayer has a tax-free dividend allowance (currently set at £2,000) per tax year, which means that £2,000 of profit can be extracted from your business tax free, before dividend taxes kick in.
This is in addition to your personal allowance, currently set at £12,570. The personal allowance is the amount each UK taxpayer can earn before paying income tax.
Therefore, you can combine a tax efficient salary and dividends to extract profits from your business tax efficiently.
Be careful: If you receive dividends from shares you hold, be careful you are not already utilising your tax-free dividend allowance
Tax Tip: Paying yourself in dividends as opposed to a full salary, means you are exempt from paying National Insurance contributions.
Who benefits from dividend payments?
Dividends are currently taxed at lower rates than a salary, with a top dividend rate of 38.1% (rising to 39.35% from 1 April 2022), compared with a top salary tax rate of 45%.
However, dividends are paid after corporation tax, currently 19%, but rising to 25% for profits before tax from £50,000 and above.
Be careful: You must be making a profit (after tax) to make use of dividend payments. So as long as your business is profitable after paying corporation tax, you and any shareholders in your business can enjoy more of the profits of your business tax efficiently, via dividend payments.
You may see headlines around dividends being paid out to investors who hold shares in a company. What this means is that the business they hold shares in is profitable and can afford to pay out profits, representing ‘a return on investment’.
In times where stock prices may go up and down according to external factors separate from the company’s performance, the payment of dividends can provide comfort to an investor and more money to invest if you so wish, for example to buy more shares.
However, for owner-managed businesses, in other words limited companies with one to three directors, it is unlikely you will have lots of shareholders to pay dividends out too, and you may not need to take money or profit out of your business. If you retain profit in the business, you can use it for future reinvestments in the business at a lower rate of tax.
You will still pay tax when you eventually take profit out of your business or wind up your company.
What are the risks and disadvantages of taking dividends?
Paying the tax on dividends, although lower than other forms of profit extraction, can still be quite onerous.
For example: a company director may take out a ‘tax efficient’ salary i.e. a salary where no income tax is due up to their personal allowance, then any profit above this amount can be taken as dividend payments.
But while salaries are an allowable expense, which basically means that any salary you take will also mans a reduction in your corporation tax bill, the same cannot be said about dividends.
Dividends can only be paid out of profits and then they are then charged at the dividend rates. Dividends are not treated as ‘earnings’ either for pension contributions.
Setting a pattern of paying dividends can lead to that income being expected and relied upon. In the unfortunate event of divorce, the family courts can take regular dividend income into account as a matrimonial resource.
Those who apply for income-based support (which has seen more attention due to the Covid pandemic) cannot include dividends as part of their income.
Be careful: If you accidentally take a dividend that is not covered by profits, then there is a risk that you will have taken out a loan which must be repaid quickly back to the company.
Recommendations:
It’s very likely your company will need funds for future plans of growth, which means that it is sensible to retain some profits in the company rather than extracting all your profits.
There is also the consideration of keeping a buffer of cash in your business for unexpected situations. The COVID pandemic is one very good example where lots of businesses have suffered due to a lack of cash flow for a long period of time due to depressed or low trading.
Perhaps also your business maybe cyclical in terms of busy trading periods, and retaining cash flow to keep your business moving in ‘low season’.
Be careful: it is not a good idea to use your company as a ‘piggy bank’ and keeping too much cash in the business, as the cash will not qualify for Business Property Relief (BPR) from Inheritance Tax on death, unless you are keeping lots of cash in the business for a clear reason.
when is it a bad idea to take a dividend?
An example where it might be a bad idea to take dividends is if a business is being sold - paying a large dividend could risk impacting a deal being struck. Furthermore, if you wind up or close your company, you may find you could benefit from a lower rate of tax on liquidation and potentially an ability to access Business Asset Disposal Relief at 10% for the first GBP1m of gains.
There are also other occasions where taking a company dividend may not be a good idea, including:
If you are going through a divorce or bankruptcy;
If you are about to leave the UK to become non-resident, as it may be sensible to delay payment until you are non-longer UK tax resident;
Dividend payments are just one way to extract money from a company – beneficial for some, but not for others. Given that taking money out of a company has a number of implications in the form of legal, tax and accounting, businesses should seek professional advice prior to making these decisions.
You can contact us for a complimentary 30 minute consultation to discuss your limited company’s tax and accounting needs. Mirandus is a chartered accountancy and chartered tax advisory business partnering with individuals and businesses with full accounting support and tax advisory services, offered as standard no matter your size or industry.
