As a self-employed contractor, there are many benefits to setting yourself up as a limited company. One of these is the payment of dividends, which is a tax-efficient way of distributing your profits. As a contractor, consultant or freelancer who is also a shareholder in your own company, this can make up the bulk of your income.
This article explains how dividends are currently taxed. For information on how they were taxed before the rules changed on 6 April 2016, please see this guide.
Retained profit is simply the surplus money a company has after paying all of its expenses, taxes (e.g. corporation tax and VAT) and employee wages. While a profit may be declared at the end of each financial year, the retained profit is the sum total currently held by the company.
If the company has shareholders, then this profit can be distributed to them via dividends. The amount that each shareholder is entitled to is based on how many shares they hold, so a 50% shareholder should get half the annual dividend distribution. However, it is the company directors' decision what amount of the profit is paid out in dividends each year, and any excess can remain in the company's account.
The great benefit of being paid via dividend as opposed to a salary is that you don't have to pay National Insurance Contributions (NIC) on dividend payments. However, dividends are still taxed. Prior to April 2016, this tax was calculated by "grossing up" net dividends via tax credits. The current system uses a simpler scale of fixed rates to calculate tax payable.
As a self-employed contractor operating via your own limited company, you are responsible for informing HMRC of the dividend amount that you have received. You should do this when filling in your annual self-assessment tax form.
The first £2,000 of dividend payments is tax-free, but this isn't taken off the total amount used for calculating your tax rate. Tax on dividends is worked out after tax has been taken from your other earnings, including your salary and any taxable savings or investments. Your tax band is calculated based on your total income, including salary, dividend payments and any other sources, minus your personal allowance.
Note that the old system gave you a dividend allowance of £5,000, but this was cut to £2,000 from 6 April 2018.
As an example, here is how a contractor taking home a £11,850 salary plus £50,000 in dividends would work out their dividend tax liability for the 2018/19 tax year.
The £11,850 salary is tax-free as it is equal to the 2018/19 personal allowance and so can be disregarded.
The first £2,000 of the dividend payment is also tax-free, leaving £48,000 for tax purposes. The first £32,500 is charged at 7.5% (basic rate), while the remaining £15,500 is taxed at the higher rate of 32.5%.
The amount payable in tax is therefore £2,437.50 + £5,037.50 = £7,475.
Legally, as a limited company, you need to hold an annual board meeting to agree the dividend declaration and keep the minutes of this meeting in the company records. If you are the sole director of the company, this is still required even if it's just a formality, and paper records should be retained in case of investigation by HMRC.
Once dividend amounts have been decided, each shareholder should be sent a dividend voucher, either on paper or digitally (via email or automatically generated by your accounting software). This should include the following information:
This should also be signed by the company director.
It's up to you how often you distribute dividends, but quarterly payments are normal and make for the simplest recordkeeping. Remember that you cannot make payments if you do not have enough retained profit to cover them. Doing this is classed as illegal or "ultra vires", and you could be subject to HMRC penalties or further action.
Dividend payments can be staggered in order to reduce your tax burden. If you know that you will be earning considerably more this year than you will be the next – for instance, if you are planning on taking a career break – then you should delay distributing some of your profits until the second year, reducing the amount of tax payable by splitting the distribution over two separate tax years.
Appointing a low-earning or non-working spouse as your co-director or business partner can also have tax benefits as you can take advantage of their tax allowance, again paying fewer higher-rate taxes as a result.
Shareholders can waive their right to a dividend, but this needs to be done for sound commercial reasons or the practice may attract unwanted attention from HMRC.
As a contractor working through a limited company, you may have come across the notorious IR35 tax legislation. This is designed to stop full-time employees of a company claiming to be self-employed contractors for tax purposes. If you fall foul of this regulation, you will be required to draw down the bulk of your company's income in the form of a "deemed salary". A fixed 5% administration allowance can be permissible to cover the costs of running the company, but after this you will be required to pay full PAYE income tax and NIC on your salary as if you were a permanent employee of the company that you are contracting for.
It's important to ensure that you are fully IR35 compliant before paying yourself a dividend as the financial consequences of being caught out can be very damaging.