You’ve probably heard the word ‘dividends’ getting thrown around in business circles before but may not completely understand what it means. To give you a better idea of what dividends are and how they work, this guide will cover:

  • What is a dividend?
  • Main types of dividends
  • How do dividends work?
  • When is it best to issue a dividend as a small business?
  • How do I issue a dividend?
  • How do I get taxed on dividends?

What is a dividend?

In a nutshell, a dividend is a sum of money that a limited company pays out to individuals and companies that own shares in the company –– its shareholders. If your company makes a profit, you can distribute these earnings to shareholders via dividends. 

Dividends are a key incentive for people to invest in your business. Companies that consistently pay out dividends are typically the most stable over time since they attract more investors that help fund them. 

As the director of your company, you can also choose to pay part of your wage in dividends. As you get taxed less on dividends than a salary, many business owners choose to subsidise their wages with dividends. We’ll explain more about how dividends taxes work later in this article.

Limited companies are the only ones that can pay out dividends since they’re the only ones that issue shares. As sole traders don’t issue shares, they can’t pay out dividends. The same rule applies to partnerships and LLPs (limited liability partnerships).

Main types of dividends

Dividends are usually paid out on your company’s common stock, an investment representing an ownership share in your company. 

You have several options for what type of dividends to pay out, as listed below:

Cash dividends

This is the most common dividend and preferred by small companies. You generally pay cash dividends directly into the shareholder’s brokerage account. Cash dividends also allow shareholders to keep the money for themselves. 

Stock dividends

You can also pay investors with additional stock shares in your company. Paying shareholders in stock dividends means they own more of the company and receive more dividends over time. The added benefit is that they don’t get taxed Income Tax on them.

Special dividends 

You’ll typically issue special dividends to distribute profits you’ve accumulated over several years or that you have no immediate need for and don’t recur like cash or stock dividends. You can use special dividends to show trust in the company’s long-term value and improve shareholder confidence.

When is it best to issue dividends as a small business?

The most important rule to remember is that you can only pay yourself and your shareholders dividends if your business is profitable. Otherwise, it’s called an ‘unlawful dividend’. A dividend should also be included in your tax return according to the date it was declared payable. As such, you don’t have to assign your dividends paid to any specific dates.

You can pay dividends as often as you’d like. However, doing so quarterly or monthly is usually the preferred method. Just make sure you leave enough cash left in the business after paying your taxes, liabilities and other expenses to pay your future outgoings.

If you own a company and work as a contractor, you can’t take out dividends on contracts that fall within IR35. The IR35 includes two sets of tax legislation designed to combat tax avoidance by workers and the firms hiring them. To comply with these rules, you must take all income from contracts within IR35 as a salary. 

You can find out more about what the IR35 legislation means on the government website.

How do I issue a dividend?

Before you issue a dividend, you must hold a directors’ board meeting to ‘declare’ the dividend and keep the minutes of the meeting. If you’re the only director, you can’t call a board meeting, but you must still keep a record of your decisions to make sure you fill in the correct paperwork for declaring dividends. 

You need to issue a dividend voucher for each dividend your company issues. The dividend voucher must include the following information:

  • Date the dividend is paid
  • Your company name
  • Names of the shareholders you pay the dividend to
  • Dividend amount

You should give a copy of the voucher to each shareholder receiving the dividend and also keep a copy for your records. Dividends are usually distributed to your shareholders according to how many company shares they own. 

For example, if a shareholder owns 20% of the company shares, they should receive 20% of the dividend distribution. If someone owns 50% of the shares, then they receive 50% of the dividend, and so on. 

How do I get taxed on dividends?

Your company doesn’t have to pay tax on dividends it issues. However, your shareholders may need to pay tax on the dividends received based on their circumstances, as we’ll explain in the next section. 

As a limited company, neither the company nor its employees need to pay National Insurance Contributions (NICs) on dividends. Therefore, running your business as a limited company can be a tax-efficient way to operate. However, if you take a higher salary than the relevant National Insurance (NI) thresholds, both you and your employee’s NICs become payable. For this reason, limited company owners often combine dividend payments with a low salary to manage their business and personal finances tax-efficiently. 

What is the tax-free dividend allowance for shareholders?

Shareholders of a company (including yourself) do not pay tax on dividend income that falls within the Personal Tax-Free Allowance of £12,570 in 2021/22. They also get a Dividend Allowance of £2,000 in the 2021/22 tax year. 

If you subsidise part of your salary with dividends, you’ll be taxed less than if you only take out the entire amount as a salary. You can learn more about the most tax-efficient way to pay yourself in our guide ‘How much in dividends can I pay myself tax-free?’. 

Shareholders only start getting taxed on dividends once they’ve used up their Personal Allowance and the tax-free Dividend Allowance. The rates are as follows:

  • Basic-rate taxpayers pay 7.5%
  • Higher-rate taxpayers pay 32.5%
  • Additional-rate taxpayers pay 38.1%.

For Scottish taxpayers, the Income Tax is based on the Scottish Income Tax Rates, but they still need to calculate and pay dividends tax using the UK tax rates and thresholds.

How Countingup can help

If you’re new to freelancing or running a limited company, figuring out your tax obligations can be confusing. Without a complete understanding of UK tax rates and where your business falls in relation to them, you could end up paying more in tax than you need. 

By setting up a Countingup business current account, you can manage all your financial data in one place. The app comes with free built-in accounting software that automates the time-consuming aspects of bookkeeping and taxes. You’ll receive real-time insights into your business finances with profit and loss reports, tax estimates, and unpaid invoices. 

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple, and straightforward! Get the Countingup app to apply for your business current account in minutes. All you need is proof of ID and a selfie. Download the app here.