How Do Dividends Work?
Dividend – a word you’ll definitely hear if you’re looking to make investments in company shares, or if you’re a limited company thinking about offering a share scheme to potential investors. But what are dividends? And how do they work?
What is a dividend?
A dividend is an amount of money paid out to invested shareholders of a limited company. If you own shares, the amount you are paid in dividends is usually directly proportional to the number of shares you hold.
Limited companies are the only types of business that can issue shares, making them the only businesses that can pay out dividends. Partnerships, Limited Liability Partnerships (LLPs) and sole traders do not issue shares, and therefore cannot pay dividends.
How do companies pay dividends?
Dividends are most commonly proposed and calculated as part of the financial statements at the end of a company’s financial year. A limited company is only allowed to pay out dividends if the company has enough available profit. Corporation tax must be deducted first from the company’s profit and dividends can be paid out from the remaining amount.
So in short, dividends are paid from post-tax profits.
Unfortunately, cash in the bank doesn’t mean anything on paper if the company hasn’t made a profit. It is illegal for a company to pay out dividends even if it has enough available cash (capital) to do so – dividends can only be paid from a company’s profit, either from the current year or from reserves of previous years’ profits.
Do all limited companies pay dividends?
No, not all limited companies pay dividends. A portion of a company’s profits can be voluntarily earmarked for dividend payments, however, paying dividends is not always adopted by every limited company.
High-growth companies sometimes choose to keep profits as retained earnings using them to reinvest in the company during its growth, whereas more mature companies may decide to adopt a dividend policy to offer direct cash rewards for shareholders. Dividends are attractive incentives for investors to become shareholders, because of the potential to receive sizeable earnings from the company in the future.
Types of dividend
Cash dividends are the most common types of dividends, but they can also be paid in the form of additional shares which are known as ‘stock’ dividends – so essentially a way of reinvesting in the company. This method of payment benefits the shareholders but doesn’t have an impact on the company’s cash balance or cash flow.
You can find out more about other types of dividends here – Types of dividends
So how do dividends work?
Here are some examples:
Josh runs a small soft drinks company and made a profit of £2,000 in the current year. The company has also retained £8,000 from previous years’ profits on which corporation tax has already been paid.
So allowing for 19% corporation tax on this year’s profit (19% of £2,000 = £380), the company is left with £1,620 for this year. Josh’s company can now pay a maximum total of £9,620 (£8,000 from previous years + £1,620) to shareholders as dividends.
Francesca owns a tech company that made a post-tax profit of £100,000 in each year of 2017, 2018 and 2019. The company has paid out dividends of £50,000 each year for those three years leaving £150,000 stored in retained earnings as company equity.
However, in 2020, Francesca’s company made a loss of £100,000. The retained earnings still stand at £150,000 (£50k x 3 for 2017, 2018 and 2019) so the company can choose to pay dividends from a pot of £50,000 made up of the retained earnings minus the loss of £100,000 in 2020.
Do I have to pay tax on dividends I receive?
Because dividends are classed as income, they are taxable. However, the rate at which they are taxed is different. They are also given special tax status in many countries.
For example, in Australia, dividends are taxed differently depending on whether the shareholder is a resident or non-resident of Australia. In the US, the dividend tax rates you pay on ordinary dividends are the same as the regular federal income tax rates for that year.
How much tax do I pay on dividends?
As an individual shareholder, you do not have to pay tax on any income from dividends that fall within your personal tax allowance (this is the amount you can earn each year without paying any tax on it). You are also given a dividend allowance each year.
For example, in the UK for the year 2020/2021, the dividend allowance amount is £2,000 – meaning that you pay no tax up to £2,000 of dividend income, no matter how much other income you might have. You will only pay tax on dividend income that is above your dividend allowance.
If you receive stock dividends rather than cash dividends, they will never be taxed until the shares you hold are sold. They will then be taxed based on the current tax rules at the time of sale.
Find out more about dividend tax here – Dividend tax explained
Can I pay myself with dividends or should I stick to PAYE?
This is a common question that many new business owners ask, and the answer very much depends on your circumstances.
A PAYE salary works differently from dividends because it is liable for government-appointed salary taxes at the rate applicable for your salary bracket. As mentioned previously, dividends are taxed, but at a different rate to salaried income which makes them an attractive option for limited company directors.
Paying yourself a salary is a cost-effective way of taking money out of your business, but once you move through higher salary brackets, this method of payment starts to become less efficient. Essentially, deciding whether to pay yourself a salary or dividends will depend on how much you’re earning and your tax threshold.
To explore and understand the best options for you and your business, speak with an accountant for specialist advice to best suit your individual circumstances.