Contractors who are thinking about setting up their own Limited Company should make sure they understand all the ins and outs of how Limited Companies work. One important area to understand when it comes to getting paid and paying tax is the importance of dividends. This article will provide a brief overview of Limited Company Dividends.
What Are Dividends?
Dividends are payments that a company can make to their shareholders if that company has made enough profit that year. Companies must not pay out more in dividends than they have in available profits from their current and previous years of business. They also cannot count dividends as part of their business costs when it comes to working out their Corporation Tax. Dividends have to be paid to all shareholders and to pay the dividend the company must:
- Hold a directors meeting for the purpose of declaring the dividend
- Keep detailed minutes of the meeting, regardless of whether there is only one director.
How Are They Issued?
Every dividend that the company issues must be written as a voucher that shows
- the date
- the company name
- the name of the shareholders who are receiving a dividend
- the amount of the dividend
- the amount of the dividend tax credit
How Will Dividends Affect My Contractor Earnings?
For many years now contractors have worked out that they are able to maximise their net earnings by working through their own Limited Companies. By paying themselves lower salaries and then receiving the balance in dividends out of the company profits. That’s because taxation rules mean that any dividends paid out of the profits of a limited company (after corporation tax has been taken). They do not attract any further tax so long as they stay below the higher tax threshold; similarly the dividends are not subject to NIC’s (National Insurance Contributions) either. What this means, in a nutshell, is that contractors pay less tax on dividends than they do on salaries.
How Exactly Are Dividends Taxed?
Dividends have a basic rate of tax of 10% but because the company has already had corporation tax taken out of the company profits the dividend income is ‘franked’ by a dividend tax credit. Which means that HMRC understands that the corporation tax that has already been paid and that that covers the 10% tax on the dividend. Which means that a contractor can basically earn up to £32,010 (on top of their basic £9440 tax allowance) without paying any additional taxation.
Similarly, on any dividends paid between the £32,010 threshold and the top threshold of £150,000 contractors will have an income tax rate of 32.5%. But this too will be discounted by the same 10% because of any corporation tax that has already been paid. This means that the contractor will actually end up paying only 22.5%. Anything above £150,000 is charged at 37.5% and is discounted to 27.5%.
As mentioned above, these dividends do not have to pay NIC, so contractors who take dividends pay neither employee NIC’s nor employer’s NIC’s from their limited company.
Dividends or Salary?
It is clear that any contractor who takes a basic salary and then pays themselves the balance in dividends is going to end up paying a great deal less out in tax and NIC’s. In both instances, a contractor will get up to their personal allowance of £9440 tax-free. But then, between £9440 and £41,450 the salaried contractor will pay 20% income tax and 25.8% (and don’t forget that limited company contractors also pay 13.8% NIC). While the contractor who takes dividends pays no tax on those dividends. A contractor would be crazy not to take the route of least taxation!
What About Personal Allowances Through Dividend Splitting?
There are additional benefits available to those contractors who have chosen to split the ownership of their limited company with their spouse or civil partner. If they have done this they can benefit additionally by taking advantage of their spouse’s tax allowances (provided the spouse is not doing so already through their own income) through something known as ‘income splitting.’ With an income splitting a contractor, is able to allocate 50% of the company shares to their spouse and to retain 50% themselves. Dividends are always paid according to shareholdings in the company so the contractor would be receiving 50% of the dividend, and the spouse would receive the other 50%. Doing this would double the tax allowances available and would mean that the contractor and their spouse could earn as much as £82,900 from the contractor’s limited company without paying out any more tax or NIC, provided they opted for the basic salary / dividend route.