Limited company directors’ salaries and dividends

There are several ways that directors can be paid by a limited company. For example, a company can pay directors salaries, or if a director is also a shareholder, the company can pay dividends.
It is therefore important to ensure that directors are paid in the most tax effective way.

WHAT ARE DIVIDENDS?

When a company makes a profit after paying all of its costs, liabilities and taxes for the financial year, it can distribute the profits amongst its shareholders through the payment of a share dividend.

Dividends can be paid from the previous year’s retained profits or from any profits that are made in the current financial year that will not be distributed among the shareholders(i.e. profits that will remain in the company’s business bank account).

Typically, dividends are distributed according to the number of shares a shareholder has. For example, a shareholder who holds 30% of the issued share capital will be entitled to receive 30% of the dividend, i.e. 30% of the profit that is being distributed.
Although in recent years the level of tax payable on dividends has increased, this remains the most tax efficient method of paying a director who is also a shareholder. That is because no National Insurance contributions are deductible from dividend payments and the tax rate is lower than the tax rate that is payable on salaries.

HOW IS A DIRECTOR PAID BY DIVIDENDS?

To calculate how much dividend you can earn as a director and shareholder:

  • Calculate the net profit that the company has available by adding the current profit to its retained profit
  • The total figure is the maximum amount that can be distributed as a dividend payment (When considering dividend payouts, it is worth remembering that the company will have ongoing liabilities that need to be paid such as leases and loans. Sufficient funds should be retained to ensure these financial obligations can be met).
Although limited companies generally make dividend payments at the end of their financial year, payments can be made at any time providing a meeting of the directors has been held and the payment of dividends has been greed. The minutes of this meeting, which must be taken even if there is only one director, should include:
  • The date of the meeting
  • The amount of the dividend payments and
  • The date on which the dividends will be paid

Once those decisions have been made, a dividend voucher must be created for each shareholder. It should include:
  • The company’s name
  • The name of the shareholder receiving the dividend payment
  • The amount of the dividend payment
  • The date on which the dividend will be paid
 

Each shareholder who receives a dividend must be given a copy of their dividend voucher. A copy should also be retained by the company for its own records.

Limited Company Director Salaries And Dividends

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WHEN IS THE BEST TIME FOR A COMPANY TO MAKE DIVIDEND PAYMENTS?

Providing dividend payments do not exceed the company’s profits, dividends can be made at any time at the discretion of the owners of the company. For accounting purposes, it would be advisable for these payments to be paid regularly – e.g. monthly, quarterly or annually.
Directors who are also shareholders should maintain separate salary and dividend payment records.

HOW IS TAX PAID ON DIVIDEND PAYMENTS?

The company is not liable for taxes on the dividends it pays to its shareholders. The shareholders who receive dividend payments may be liable to pay tax on these depending on how much they receive and their own personal tax situation as indicated by completion of their annual self-assessment tax return.

For the tax year 2019/2020, there is a dividend allowance of £2,000 which means that the first £2,000 of dividend payments that a shareholder receives is not subject to any tax deduction. In addition, each taxpayer currently has a £12,500 personal allowance which is also not subject to any deduction of tax. However, once the £12,500 personal allowance threshold has been reached, there are other considerations.

SALARY OR DIVIDEND?

Company directors who are also shareholders often draw a low salary that keeps their earnings below the £12,500 personal allowance threshold. This prevents their salary from being taxed at the current basic rate of 20% (or 45% if their salary is high enough to reach the next personal allowance threshold).

So, having taken a low salary, a director who is also a shareholder can draw additional earnings in the form of dividend payments. Using the example of a director who is also a shareholder who wishes to earn £50,000, the best way to achieve this, assuming the company has made sufficient profit, would be:

  • Draw a salary payment of £12,500 on which no tax is payable as it does not exceed the personal allowance
  • Accept a £2,000 dividend payment on which no tax is payable
  • Accept an additional £35,000 dividend payment which would be taxed at the dividend rate of 7.5% (assuming the director pays tax at the basic rate)

In this case, the director would only be liable to pay £2,662.50 in taxes (i.e. 7.5% of £35,000) and earn a net income of £47,337.50.

In contrast, a director who is also a shareholder who draws their earnings as a £50,000 salary would be liable for more taxes:

  • £12,500 of their salary would be tax free (as their personal allowance)
  • The remaining £37,500 would be taxable at the basic rate of 20%, i.e. the director would be liable for a tax payment of £7,500
  • In addition, the salary would also be subject to deductions for National Insurance (NI) contributions of £4,964

In this case, the director would be liable to pay a total of £12,464 for tax and NI contributions resulting in a net income of £37,536.

IS THERE ANYTHING ELSE TO CONSIDER WHEN TAKING DIVIDEND PAYMENTS?

While the payment strategy outlined above is most efficient from a tax perspective, there are additional factors that should be taken into consideration:

Pension contributions:

Drawing a larger salary means that larger contributions can be paid into the shareholder’s personal pension plan. An alternative option to offset the lower salary and pension contribution is for the company to set up its own pension scheme that shareholders can pay into

Share status

Each shareholder is entitled to a dividend which is payable at a fixed rate per share. However, not all shareholders will contribute the same amount of work and commitment to the company. As such, different classes of shares can be issued that carry different dividend rights and voting rights. This ensures that shareholders who do the most work can be rewarded with a higher dividend

Unlawful dividends

Dividends should only be paid when that company makes a profit. It is illegal for a company to make dividend payments in the knowledge that the company has either traded at a loss or has made insufficient profit. Such payments are referred to as ultra vires dividends. To help mitigate this occurring, it is a legal requirement for companies to:

  • Produce a dividend voucher and
  • Record in the minutes of the board meeting(s) the process by which the dividend payments were authorized
If a director who is also a shareholder accepts a dividend payment that the company cannot afford to pay, this may result in a significant director’s loan that must be paid back within nine months of the financial year end. If the money is not paid back into the company’s account within the allotted time frame, HMRC will consider it income (i.e. tax and NI contributions will be due), despite the fact that it was originally a dividend payment.

Should the company be forced into a formal insolvency process at any time, the director’s loan account must be repaid to the company and subsequently used to pay the company’s creditors
The director may also face allegations that the company has been wrongfully trading which could result in the director being prohibited from acting as a company director for up to 15 years.

Payment of Corporation Tax

As salaries are deducted as an expense on a company’s profit and loss account, any salary payment will reduce the amount of profit the company makes and thus the amount of corporation tax due. Dividend payments do not affect corporation tax liability.

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