What are dividends?

How do dividends work for a small company?

Most owner-managed companies pay the director a modest salary through PAYE and take the rest as dividends, because dividends do not attract National Insurance. The split that makes sense depends on rates that change at Budgets, so the current position is on gov.uk or with your accountant.

A dividend is a distribution of profit, not a cost. The company earns profit, pays corporation tax on it, and what is left is available to distribute. If there is no profit after tax, or accumulated profit from earlier years, there is nothing to distribute and any payment is unlawful.

Paying one is a formal act, even in a one-person company. The directors resolve to pay it, minute the decision, and issue a dividend voucher to each shareholder showing the date, the company, the shareholder and the amount. Dividends are paid in proportion to shareholdings, so two equal shareholders get equal dividends.

A worked example

A company with one director-shareholder has made £40,000 profit for the year. Corporation tax at the current rate is provided for, leaving, say, £30,000 of post-tax profit available. Retained profit from earlier years is nil.

The director wants £2,500 a month. Each month he minutes an interim dividend of £2,500, issues himself a voucher, and transfers the money. Over the year that is £30,000, exactly what is available, and each one was lawful when declared because the profit to that date covered it.

Had the year gone badly and profit after tax come to £18,000, the last £12,000 of dividends would not have been covered. They become a loan from the company to the director, sit in his loan account, and need to be repaid or dealt with.

What do people get wrong?

• —Paying dividends from the bank balance rather than from profit. Cash in the bank might be VAT you are holding or a customer's deposit.
• —No paperwork. Without a minute and a voucher, HMRC can argue the payment was salary, with the tax and National Insurance that follow.
• —Forgetting that dividends are taxed personally. The company pays nothing on them, but the shareholder reports them on Self Assessment and pays tax above the allowance on gov.uk.
• —Unequal dividends to equal shareholders, which is not allowed without different share classes.