Running a small business comes with numerous responsibilities, especially when it comes to managing your finances. One area that often causes confusion is the taxation of dividends.
Understanding how dividends are taxed can significantly impact your financial planning and tax liabilities.
What Are Dividends?
Dividends are payments made to company shareholders from the profits of the company after all business expenses and tax liabilities have been paid.
For many small business owners, especially those who operate as limited companies, taking income as a combination of salary and dividends can be the most tax-efficient strategy.
Why It Matters for Small Businesses
For small businesses, efficiently managing how profits are distributed can lead to significant tax savings.
Unlike salaries, dividends do not attract National Insurance Contributions (NICs), making them a popular choice for business owners looking to minimise tax liabilities.
How Dividends Are Taxed
Dividend tax is calculated and paid through the annual self-assessment tax return process.
Here’s how it breaks down for the 2024/25 tax year:
Dividend Allowance
Each shareholder benefits from a £500 dividend allowance for the year ending 5th April 2025, which means the first £500 in dividends is tax-free. This allowance has been reduced from £1,000 in the previous year.
Tax Bands and Rates
After the dividend allowance, the tax rates are as follows:
- Basic Rate: 8.75% on income between £0 and £37,700
- Higher Rate: 33.75% on income between £37,701 and £125,140
- Additional Rate: 39.35% on income over £125,140
Example Calculation for 2024/25
If a company shareholder takes a £50,000 dividend after receiving a salary of £9,096:
- The first £12,570 of income is tax-free (personal allowance).
- The first £500 of dividends is tax-free (dividend allowance).
- The next £37,200 of dividends are taxed at 8.75% = £3,255.00.
- The final £8,826 of dividends are taxed at 33.75% = £2,978.78.
- Total dividend tax payable = £6,233.78.
To avoid paying higher rate tax, it’s recommended to limit dividends to £41,174.
Avoiding Common Mistakes with Dividends
1. Illegal Dividends
Dividends can only be paid if your company has made a profit. Taking dividends that exceed your company’s profit is illegal and can result in severe penalties from HMRC. These are classified as ‘overdrawn director’s loans’ and must be repaid within 9 months of the year-end to avoid additional tax and interest.
2. Failing to Keep Proper Records
Proper documentation is crucial when issuing dividends. Ensure you hold a board meeting to declare dividends, even if you are the sole shareholder. Prepare a dividend voucher detailing the date, company name, recipient’s name and address, the number of shares owned, and the total dividend payable.
Tax-Efficient Strategies
Combining Salary and Dividends
For many small business owners, the most tax-efficient method is to take a combination of a low salary and dividends. This approach minimises NICs and maximises personal allowances and lower tax rates.
Retained Profits
You don’t need to withdraw all your profits at the end of each financial year. Retaining profits within the company can provide a financial cushion for future business needs or personal income management during lean periods.
Why It Matters
Understanding dividend taxation is essential for small business owners to:
- Maximise Tax Efficiency: Reduce overall tax liabilities by using a mix of salary and dividends.
- Ensure Compliance: Avoid penalties from HMRC by adhering to the rules for dividend payments.
- Plan Financially: Retain profits for future use and manage personal income more effectively.
Navigating the complexities of dividend taxation can be challenging, but it’s a crucial aspect of managing your small business finances.
By understanding the rules and employing tax-efficient strategies, you can optimise your income and ensure compliance with HMRC regulations.
At Accounts Direct, we’re committed to helping small businesses in the UK thrive. Contact us today for expert advice and support on all your accounting needs, including dividend taxation and financial planning.