Small business dividends: how do they work?

Dividends are sums of money that a company pays to its shareholders when it’s in profit. Larger companies such as those that are listed usually pay dividends once or twice every year, while smaller companies may pay them more often, depending on the needs of the founders. Single-shareholder companies, for example, may pay dividends monthly as this can be more tax-efficient for the owners than receiving a salary. So, how do company dividends work?

What are dividends?

Dividends are payments made to a company’s shareholders, and are usually made in cash although sometimes a dividend can consist of other share capital or assets. They are the way in which a company distributes its after-tax profits to its owners. The company’s directors decide when dividends will be paid, and how much they’ll be. Each class of shareholder will receive the same amount, pro rata, to the number of shares they hold.

In the case of large and profitable companies, dividends are normally declared once or twice a year. Start-ups and early stage companies however will not usually declare dividends, as any profits are put back into the business to increase growth.

Investors who hold shares in listed companies will often choose to buy the shares of companies who declare regular dividends if they’re looking for income rather than capital growth.

Are there rules about paying dividends?

The most important rule to remember about paying dividends is that you can only declare a dividend if your company is profitable. You work out how much dividend to pay after you have calculated your profits net of corporation tax – in other words, after all other expenses have been paid. All shareholders of the same class must receive the same amount.

A dividend paid when a company is not in profit is called an ‘unlawful dividend’.

Before you think about declaring a dividend, you should check your company’s Articles of Association, as they normally contain provisions about when and how dividends are declared. It’s also possible if there’s a shareholders’ agreement, that dividends are covered in this document too.

The Articles usually provide that, while the directors can recommend a final dividend, this is confirmed by the members in a general meeting, normally the annual general meeting. The members can decide to pay a lower dividend than the directors recommend but can’t award themselves a higher amount.

The company’s Articles may provide for a ‘record date’ to be set so they can work out which shareholders are entitled to receive a dividend on a given date, and public companies always use record dates as their shareholders are constantly changing.

If a director authorises the payment of a dividend that is more than the company’s profits available for dividends, they may be personally liable to repay this to the company, even if they’re not a shareholder.

Can I pay a dividend if my company isn’t in profit?

No, you can’t pay a dividend if company doesn’t have profit available, but you can reduce the capital of your company in order to create a distributable reserve to declare a dividend.

Are there different types of dividend?

If you have created different classes of shares, you can declare different types of dividend. Holders of preference shares may have preferential rights to dividend, often in a fixed amount or as a fixed percentage of the nominal value of their shares. This means that they will be paid this amount ahead of ordinary shareholders, but it doesn’t mean they have an absolute right to receive a dividend.

A special dividend is a dividend that’s paid outside of the normal course of dividend payments. These are sometimes used to return surplus cash to shareholders, or in connection with a merger or acquisition.

What paperwork do I need to complete to declare a dividend?

Provided you have checked that you have enough profit to declare a dividend, you need to call a meeting of the directors, and state your intention to declare a dividend, and prepare a tax voucher for each shareholder that shows the amount of dividend and the date it was paid. You then pay the dividend and send the tax vouchers to the shareholders.

Does the company need to pay tax on the dividend?

Dividends are paid after all expenses have been deducted from profits, and that includes corporation tax. So, the company doesn’t pay tax on the dividend, but the dividend can only be paid after corporation tax has been paid.

If I receive a dividend, what tax will I pay?

If you receive dividends of over a certain amount (£2,000 in the 2021/22 tax year), you will need to pay income tax on your dividends, after taking into account your personal allowance.

If you are the sole shareholder of a business, it can be more tax-efficient to receive dividends rather than a salary, as wages are subject to income tax and national insurance.