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If you are contractor working through your own limited company, it is a good idea to divide your pay up into salary and dividends to increase tax efficiency.

Setting this up in the right way will mean you will end up paying less tax as a contractor. We have put together this guide to help you understand how dividends work, and to ensure you are making the most out of your earnings.

What are dividends?

A dividend is a payment a company makes to its shareholders, with retained profits.  The payments are made using the money that is left over after paying all expenses, liabilities and taxes. Dividends must be distributed between shareholders in a certain way. How much someone receives, depends on the percentage of company shares owned by the individual. If a shareholder owns half the company shares, they will be entitled to 50% of the dividend pay-out.

Any money that is not paid out as a dividend will remain in the company’s bank account. Many contractors choose to set up a limited company, as it is the most tax efficient way of working. Shareholders often choose to draw a small salary, which is subject to employees and employer’s National Insurance, and dividends, as these are exempt from NICs.

How often are dividends paid?

It is up to the owner of the business to decide when dividends are paid, and the amount of each one. They can decide to take dividends at any time, as long as there are enough profits in the business. All shareholders will receive dividend payments at the same time.

Dividend declarations and vouchers

To abide by the law, limited companies must keep a record of all the dividend payments they make. A meeting will have to take place, all shareholders have to be present, and all important details must be recorded. If you ever undergo a HMRC investigation, you might be asked to provide this information.

In addition, the directors will need to provide a dividend voucher to all the shareholders. This must include:

  • Limited company name
  • Shareholder’s name and address
  • Number of shares owned by the shareholder
  • Total dividend being paid
  • Total tax credit
  • Date
  • Director’s signature

Tax on dividends

Shareholders are still liable to pay tax on the dividends they receive from limited companies. Companies would have already paid Corporation Tax on their profits, so a notional 10% tax credit is applied to the dividend. This credit is viewed by HMRC as a deemed payment of tax.

After that, dividend payments are calculated depending on personal income. As a basic rate taxpayer, you will not pay any tax on dividends as the 10% dividend tax rate is cancelled out by the tax credit.

As a higher rate tax payer, a 32.5% tax rate will apply, but after taking in to account the tax credit, only a further 25% is due.

As an additional rate tax payer, a 37.5% tax rate applies, as with the other examples, only 30.56% will be due, once the tax credit has been applied.

Dividends and IR35

If you operate inside IR35, you cannot draw dividends from a company. This is against HMRC rules and must draw your income as a salary. If this is the way you operate, you will be liable to pay PAYE income tax and NICs on your income.

If you are in doubt about your IR35 status, it is worth seeking the advice of a professional, as you could face significant financial penalties if you take dividend income when you should not.

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