Dividends are the classic way of saving tax for owner-managers of limited companies. Tax is actually the wrong word to use now that the basic rate of income tax is the same as the small companies rate of corporation tax. The real saving with dividends comes through not paying National Insurance contributions, which are levied on salaries at a combined rate of 25.8%. Dividends, like all forms of investment income, are exempt from NICS so you can avoid this completely.
A company making annual profits of £98,000 and owned by a husband and wife in equal shares could save them over £15,000 a year with the correct mix of salary and dividends.
However, you must get your dividend procedure right otherwise the Revenue could disallow them and assess all cash taken out of the business as salary instead, with a huge increase in tax and NI.
Firstly, you must make sure there are sufficient profits in the business to cover your dividends. This might mean preparing interim accounts on a regular basis to verify that sufficient profits existed at the time the dividends were declared, even if your business has made losses since.
Secondly, they must be properly authorised and recorded. Interim dividends must be voted by the directors at a properly convened meeting and authorised by a board resolution. They must also not be back-dated. However, a board meeting does not have to be held in an oak panelled room around a long table. If you are the sole director and shareholder of your company, you could declare a dividend whilst you are lying in bed or taking a bath! All you have to do is think that you will declare a dividend. And you can always write up the board resolution later. So smaller companies have a lot more flexibility with their dividend policy than large companies where it may be necessary to convene a shareholders meeting at 14 days notice. However, it would be wise to have contemparaneous evidence that the dividend was declared, such as an e-mail to your accountant on the day you declared it (or soon afterwards).
You should also remember that there is a law of diminishing returns with dividends. Once you are in the higher rate tax bracket dividends get quite expensive, since they are effectively taxed at 25% (or 36.11% for 50% taxpayers) and this is additional to the 20% already paid by the company (or even more if profits exceed £300,000). So always restrict your dividends to the basic rate band if you can. That way, the company can be used as a tax shelter for retained profits.
Talk to us about which combination of salary and dividends would be right for your business, taking into account all extraneous factors such as your other income, the investment needs of the company and the minimum wage regulations (most owner managers are exempt from the NMW rules - but not all).
