Dividends enable limited companies to distribute profits among their shareholders while offering tax-efficient compensation for company directors. This article, written by Simon Laurie and I, will explore the complexities surrounding dividends and what limited companies need to know. 

What is a dividend? 

Simply put, dividends are payments made by a company to its shareholders. Dividends provide limited companies with an effective way to withdraw funds while providing shareholders with regular income. However, dividends can only be issued if the company has generated sufficient profits after all expenses and tax responsibilities are met and doesn’t exceed its profits from both the current and previous years. The remaining balance specifically allocated for dividend payments is known as ‘distributable profits’.  

Learn more: How do UK companies pay dividends to their shareholders?

Tax on dividends

Two significant benefits of dividends are that companies are not liable for tax, and shareholders can earn up to £2,000 in tax-free dividends in 2022/23 and £1,000 for 2023/24. Beyond these thresholds, the tax on dividends depends on the shareholder’s income tax bracket, either 8.75% for basic rate, 33.75% for higher rate or 39.35% for an additional rate taxpayer.  

What is the dividend amount, and how is it determined? 

The dividend amount refers to a sum or the value of shares the company’s shareholders receive in proportion to their ownership stake. The board of directors will analyse the company’s relevant financial data, including management and accounts, to determine this figure. They will also consider the company’s cash requirements and future business plans. Once the amount is determined, it will come from the company’s profits, including the earnings from that year and any profits not utilised in previous years. For example, if a business generates a profit of £16,000 and has unused profits of £4,500 from previous years, this means that £20,500 is available for dividend distribution. 

When determining the dividend amount, companies should look to retain a portion of their profits to address any future uncertainties or reinvest in the business. Another reason why companies might want to retain a portion of their profits is that from a credit rating perspective, lenders would like to see net assets (retained profits) on the balance sheet growing rather than depleting or being fully utilised each year. As the balance sheet is always on public record, it is good practice to show an improved position each year in the retained profits as this helps to enhance the perceived health of the entity.   

How are dividends declared and recorded?  

Before a limited company can distribute dividends, it is necessary for the directors to officially ‘declare a dividend’ during a board meeting. This process is mandatory even if there’s just one director in the company. It should then be recorded in the meeting’s minutes. Dividends are not tied to the year-end and, therefore, can be declared at any time of the year and on multiple occasions across the year. Each shareholder receives a dividend statement outlining the payment date, number and class of shares and the amount of dividends they will receive, which they should keep with their tax records. 

Tax implications of director’s loans 

If a director withdraws more money from the company than their invested capital, aside from salary or dividends, it is referred to as a director’s loan. Taking out excess dividend payments can also be considered a director’s loan. If the loan is not repaid within nine months after the Corporation Tax accounting period ends, they’ll be required to pay 33.75% of the outstanding amount in Corporation Tax. This tax is known as section 455 and is a company liability which is only repayable to the company nine months after the year-end in which the loan is repaid or cleared via a dividend. As a result, timing of any repayment of a loan can be crucial from a cashflow perspective.  

Unlawful dividends, insolvency and legal consequences 

Limited companies must not declare and distribute dividends if insufficient funds are available in retained profits. This is a crucial legal requirement for issuing dividends. These unlawful dividends can lead to significant penalties or additional regulatory measures imposed on the company. Other types of unlawful dividends include when HMRC determines a dividend to be a salary, requiring directors to pay National Insurance Contributions (NIC) and tax. 

Even when a company faces insolvency, it may still be penalised for unlawful dividends. Liquidators will scrutinise the firm’s transactions, including dividends, before insolvency to identify any illegal transactions. If they identify any unlawful dividends, shareholders are not legally obliged to repay them; however, the directors are.