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Using dividends to pay yourself as a contractor

There are many benefits to being a contractor with your own limited company but the main advantage of trading this way is the control over the company’s finances. As the company is a separate entity to you, you will need to extract profits from it to pay into your personal bank account. The means of doing this is to distribute using dividends. What exactly are dividends and why are they so important for contractors who operate this way?

What is a dividend?

A dividend is payment made out of the profits of a company to its shareholder/shareholders. There are a number of different ways that dividends can be paid by a company to their shareholders. These include: Cash dividends, Stock dividends, Property dividends, Interim dividends and Final dividends which are payments made at the end of the financial year.

Cash is the most common form of dividend, and these are paid out in the national currency of the firm, typically by electronic transfer or cheque.

Dividends can be issued as a one off, or they can be a regular, recurring payment made to a shareholder and forms their main source of income. It is up to the directors of the company to decide if and when a dividend can be paid to the shareholders but it must be paid in proportion to the individual’s shareholding.

Your company cannot pay out more in dividends than the amount your company has available in profit. This includes from both the current and previous years. If you declare a dividend without having sufficient profit in the company it is illegal or ‘ultra vires’ to use the technical term, so contractors will need to ensure that they accurately calculate profits before declaring a dividend.

what is a dividend

Why use dividends?

Dividends can be issued throughout the company’s financial year or as final dividends at the yearend. As a result some shareholders, particularly those who are owners of smaller businesses, can use these as a form of regular income.

For limited company contractors, who are the sole owner and director of their business, the most tax efficient way to pay them self is through a mixture of salary and dividends. By keeping your salary low you can minimise the amount of National Insurance Contributions (NICs) you pay to HMRC and you can then issue yourself a company dividend (which does not attract NICs and have lower Income Tax rates) to top up your income.

It is for this reason that dividends offer contractors a legitimate and tax effective method of remuneration that is widely used by those in the industry.

How to take money out of your limited company – the dividend paperwork

Firstly to ensure you are issuing dividends legally, you should ensure you have enough profit in your company. To do this you should remember to deduct from your overall sales any expenses, salary and corporation tax liabilities that are due and then establish a reasonable margin for error for any unforeseen emergencies.  The remainder will be the amount available that can be paid out as a dividend.

All companies must then hold a board meeting to agree the dividend declaration. For single person limited companies with only one director this becomes more of a paper exercise to ensure records are kept up to date.

Finally, the dividend payment can be made via issue of a dividend voucher. This will need to show the:

  • Date
  • company name
  • name of the shareholder being paid a dividend, and
  • amount of the dividend

Paying tax on dividends

The good news is your limited company doesn’t pay out tax on its dividend payments. However, there may be an income tax charge for the receiving shareholders if the amount is over £5,000.

The rules surrounding tax  for dividends changed as of April 6th 2016 but from that date recipients have a £5,000 tax free allowance on dividend income, which is in addition to the personal allowance they receive for that tax year.

If you receive more than £5,000 in dividend income, the amount of tax payable will depend on the tax band you fall in to. And, if you are based in Scotland, these bands and rates will be different again as the Scottish parliament now has the power to set its own amounts. For instance, in the 2017/18 Scotland has set a higher tax band of £43,000, which is lower than the rest of the UK’s higher tax band of £45,000.

It is highly recommended that you use the services of an experienced contractor accountant if you have any questions about the timing or taxation of dividends. By finding a contractor accountant through Umbrella Exchange you can expect expert advice based on your own personal circumstances.

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