Why are dividends the best form of payment for contractors?
If you are contracting and running a limited company. the most advantageous way to take your income is via dividends, which are the division of profits among shareholders. If setup correctly, taking mostly dividends rather than a salary will mean you pay less tax as a contractor. In the current tax climate, dividend income is the most advantageous form of profit distribution for small limited companies from a tax point of view.
Low salary and high dividends
The best tax strategy as a consultant is to take the lowest possible salary. because salary payments are taxed with PAYE and National Insurance contributions. To do this you calculate your company gross profit, apply corporation tax, and then dividend up the net profit (or shareholders funds) among the shareholders according to the rules set up by your company's articles.
When can you take dividends from a limited company?
You can distribute dividends at any time. You just have to have money in the bank account to do so. But, beware, at the end of your tax year you must ensure that the total of all your dividends taken have been covered by profits earned by the company after all expenditure (including salaries) and corporation tax. Paying dividends out of untaxed earnings are illegal dividends. and against the law and you could face an investigation and severe penalties from HMRC.
Deciding when to make a dividend payment
The decision to take dividends must be approved by the company shareholders in terms of the voting rights as specified in your company's articles. Most contractor limited companies distribute even amounts of ordinary shares: typically one spouse or partner has 50% and the other has 50% (called dividend splitting or income splitting ). In this case, each partner gets 50% of the profits.
You can hold a shareholders meeting to vote on dividends, but this is no longer required. You can simply agree among the shareholders to distribute them, and then note the amounts given out in the company's annual records and its accounts (a so-called 'dividend foil,' which is a simple receipt for the dividend paid, is sent out to each shareholder--please see our article on "Dividend Paperwork '' for how to handle this very simple paperwork).
How to calculate dividends
You can take dividends whenever you like and for as much as you like, but you must ensure that the total of all dividends in your company year are not made in excess of the company’s profits after corporation tax (called 'distributable profits'). You should keep a running total of the approximate profits generated for the company year and ensure that by year end all dividend payments were only made from taxable profits.
In general terms, the approximate amount of available dividend can be calculated as follows: