How often should contractors pay themselves dividends?

Ahead of the changes to dividend tax rates from April 6th 2022, let’s revisit why limited company contractors can still benefit from a remuneration strategy combining a low salary and dividends, writes Matt Fryer, head of compliance at Brookson Group. 

Let’s also pinpoint some dividend pitfalls to watch out for, plus consider why the timeliness of dividend payments is important.

Dividends- a recap of the basics

A dividend is simply a share (or distribution) of the company’s profits, after corporation tax, that are paid to shareholders (who are also usually directors of their Personal Service Company), according to the proportion of shares that they hold.

There is no requirement to pay all the profits as dividends, or even any of them. However, most director / shareholders take the majority of the money they need personally from their company as dividends, as it is tax-efficient to do so.

The benefits of taking dividends

• The key tax planning benefits of taking dividends is that dividends generally result in higher net take-home pay than salary.
• The most common way to pay yourself as the director / shareholder of your limited company is using a mixture of salary and dividends. Keeping your salary low minimises the amount of NICs you have to pay, as dividends do not attract National Insurance. Therefore, most directors take a small salary and the remainder of their company’s profits as dividends as this is the most tax-efficient payment method.
• Directors enjoy flexibility over when they take dividends; as generally, you are only taxed on dividends when these are actually paid so if you don’t need to withdraw funds, you can retain them in your company.
• You have a tax-free dividend allowance of £2,000 per year.

Are there any drawbacks to taking dividends?

From a tax-efficiency perspective, taking your income mostly in the form of dividends is good tax planning.

However, there are certain limitations and pitfalls to watch out for:

• Dividends can only be paid out of profits. Essentially, this is based on a cumulative basis, therefore for each accounting period, you need to assess retained profits brought forward from your previous accounting period, profits arising in current period and dividends you have already taken.
• Dividends are paid after corporation tax has been deducted (unlike salary, which is a tax deductible expense).
• If you accidentally take a dividend that is not covered by profits, you will have taken out a director’s loan which must be repaid, this will have company and personal tax implications.

Get the details and paperwork right…

Contractors taking dividends should clearly document and identify in their accounting records on a ”contemporaneous basis”  i.e. record that at the point you make the withdrawal, you are taking a dividend.

Then support this by retaining a dividend voucher.

The voucher should be produced each time you make a dividend withdrawal and should detail the date, company name, names of the shareholders being paid a dividend, and the amount of the dividend.

The voucher should be signed by you as director of your company. By ensuring your paperwork is in place, this will reduce the prospect of any long and drawn out challenges from HMRC, regarding the nature of the transaction.

How to pay yourself a dividend, and how often to pay yourself a dividend

You do need to keep a track of your profit levels throughout your accounting period to ensure that you have sufficient profits from which to draw down dividends.

The best way of doing this is to ensure your accounting records are up-to-date so you are clear what funds are available to you.

Also be aware if you have any other taxable income in the period, e.g. other employment income, or rental income. Such income could impact whether you pay dividend tax as a basic or higher rate taxpayer.

In terms of how often to pay dividends, it is typical for the shareholder/director of a PSC to take dividend income on a regular basis. 

However, there is no prescriptive timing requirement and the decision of dividend frequency is made by the director.

Indeed, it is part of a director’s responsibility to decide how and when to distribute the company’s profits and, as long as the bookkeeping and paperwork is in place, our view is that it really isn’t up to HMRC to decide how you run your company and when you should take your dividends.

Paying dividends in the future (post-April 6th 2022)

As most contractors know by now, the funding of the Health and Social Care Levy will be made not only from the 1.25% increases in both Employee and Employer National Insurance, but also by increases in dividend tax to:

• 8.75% for basic rate taxpayers
• 33.75% for higher rate taxpayers; and
• 39.35% for additional rate taxpayers

Generally, by taking a director’s salary equivalent to the National Insurance secondary threshold and your residual funds as dividends, you won’t be stung twice by the 2.5% combined Employers and Employees NI increase.

Final thoughts

In conclusion, for those individuals working on outside IR35 contracts, taking dividends from your company will continue to be beneficial. However, we recommend that you speak to your accountant who can discuss your specific circumstances and recommend an appropriate tax-planning strategy, covering both how much in dividends you could consider taking and how often, in terms of dividends frequency.