Who are the winners and losers when it comes to paying and receiving dividends: Everything You Need to Know
Believe it or not it is not always in the best interest of the company or the shareholder to pay dividends.
The recent announcement from the Government that it would increase both the dividend tax and National Insurance by 1.25% has been described as another blow to business owners, particularly those that are already struggling because of supply chain disruption, labour shortages and the ongoing impact of the pandemic.
What are dividends and how do they work? In simple terms a dividend is a payment of profits (after corporation tax) to shareholders of a company. 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, whereas funds reinvested must be applied wholly and exclusively for the benefit of the company.
What’s the benefit of paying yourself dividends from your company?
From a tax perspective, it has historically been beneficial to extract income in the form of dividends, as dividends have lower rates of income tax than a salary does in addition to this, each person has a tax-free dividend allowance on top of the personal income tax allowance, this is currently £2,000, which means that tax is only payable on dividends above this rate. It can, therefore, be advantageous to utilize these allowances by taking income as a combination of both salary and dividends.
It is important for investors to check their other investments where dividends are received, as this may mean that part or all their tax-free dividend allowance for the given period has been used elsewhere. It is sometimes possible to pay dividends to your spouse to access their tax allowances, provided they are a full shareholder.
Paying yourself a dividend (as opposed to a salary), will be exempt from National Insurance contributions for both you and the company/employer. However, it is important to remember a dividend is paid out of profits after corporation tax has been paid, so business owners should take advice from their accountant.
Who benefits from dividend payments?
Businesses must be making a profit (after tax) to make dividend payments. Provided this is the case, one way in which companies can benefit from paying dividends is through shareholder loyalty and retention of investors.
From the viewpoint of an external investor, a big advantage of receiving a dividend is that it is money 'in the bank' and represents a return on investment. In times where stock prices may go up and down, the payment of dividends can provide comfort to the investor and more money to invest, for example to reinvest into more shares without risking money from other sources.
Dividends are currently taxed at lower rates than a salary, with a top dividend rate of 39.35%, compared with a top salary tax rate of 45% however, dividends are paid after corporation tax, which has increased significantly to 25% in 2023 although marginal can be claimed or profits between £50,000 and £250,000.
On the other hand, if owner managers do not need to take money out, then it may be best to keep the money in the company to reinvest in the business. However, there will still be tax to pay when the owner eventually takes the money out the company is wound up.
What are the risks and disadvantages?
Paying the tax on dividends can be quite onerous. While salaries are an allowable expense for the business which appear on the profit and loss and are, therefore deducted from a company's corporation tax liability, the same cannot be said about dividends since dividends can only be paid out of profits.
As previously mentioned, dividends are then subject to income tax (at the dividend rates) once in the hands of the shareholder. Additionally, and this could be very important for some people dividends are not treated as 'earnings' for pension contribution purposes.
If the company needs funds for future purposes or growth, then retaining money in the company can be sensible instead. Companies should factor in unexpected situations (for example, the Covid pandemic) and periods of low cash flow (may be seasonal or for other reasons) and whether paying out dividends will impact their ability to make a profit in the future. However, it is not a good idea to use a trading company as a 'piggy bank' as the cash will not qualify for relief from inheritance tax on death, unless it is being retained for a clear purpose. Conversely, if you accidentally take a dividend that is not covered by profits, then there is a risk that you will have inadvertently taken out a loan from the business which must be repaid quickly to avoid a section 455 personal tax liability for the director/shareholder. Setting a pattern of paying dividends can lead to that income being expected and relied upon, which is not a good idea. The recent pandemic has been a case in point here where businesses have had to close their doors temporarily the profits have disappeared overnight and with it any available dividends. 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.
Furthermore, investors that rely on regular dividends as their main source of income should be aware that companies can reduce the dividends paid or even not pay them at all.
When are dividends payments are not a good idea?
Although directors have a duty to deliver shareholder value, this must be balanced against practical considerations for the company. If a business is being sold for example, paying a large dividend could risk impacting the deal.
There are also instances where receiving dividend payments may not be a good idea, including:
· if you're going through a divorce or bankruptcy.
· if you're leaving the UK to become non-resident
· if you're about to wind up the company then you may benefit from a lower tax rate on liquidation (which can be liable to capital gains tax, not dividend tax), and potentially an ability to access business asset disposal relief at 10% for the first £1m of gains.
Dividend payments are just one way to extract money from a company and is beneficial for some, but not for others. Given that taking money out of a company has several implications in the form of legal, tax and accounting, businesses should seek professional advice prior to making these decisions.