The thing about a Limited Company is that it’s not your money!
The company is a completely separate entity in the eyes of the law. You may own the company but the legalities mean that you must treat all transactions with your business as being an “arm’s length arrangement”. In reality that means that you cannot just dip in and out of the bank account taking what you need when you need it. There must be a clear account kept of what monies have been taken out of the business and what they were for. This must happen at the time that the transaction occurs not later when you’re trying to sort things out for the accounts and tax returns filing. The past cannot be re-created. Trying to retro-fit transactions into categories later can be questioned by HMRC. This can all be avoided by keeping on top of your accounting as you go recording amounts that you extract from the business correctly.
So, for the self employed who operate via a Limited Company extracting money to live on is slightly more complicated as, in most cases, money will be extracted by way of a combination of dividends and salary, with the salary being taken out of the business as a cost already included in the accounts. The best combination of dividends and salary for the owner of the limited company will vary each year as the tax rates change and will depend on the personal circumstances of the individual. There is no right or wrong answer although there will be some general “rule of thumb” guides that can be found on the internet – just search for Salary and Dividends for a limited company. It’s vital that you make sure that you are looking at the information for the right tax year. Otherwise you could end up making costly mistakes. As with everything that you find on the internet, do verify the source and make sure that the information is provided by a suitably qualified accountant or tax professional. Do read the information given fully making sure that the approach described suits your individual circumstances.
Let’s look at salary and dividends in a bit more detail.
Salary
Depending on your circumstances you may pay yourself a salary from your limited company. If this is the case then each month a payment would be made from the business bank account to your personal bank account. The transaction should be described as “Director’s Salary” and posted to a Director’s Salary account in the profit and loss section of your accounting system.
Tip – a common mistake made in some accounting systems is to post the salary to a “Control Account” which is something that appears in the Balance Sheet. Whilst this may be the technically correct approach, for a one person business this is unnecessarily complicated as the control account needs to be reconciled and cleared out via journals. Posting any salary paid to a director directly to a profit and loss account ensures that it is in the right place to get the important accounting figures (profit and tax estimate) right. If in doubt – take advice from an accountant.
Unless you’re paying very small amounts (less than the Lower Earnings Limit*), a payroll will need to be set up with HMRC and the salary recorded through a payroll system with a monthly report, filed under the Real Time Information (RTI) regime, sent to HMRC. Operating in this way will ensure that, even if you are paying no tax or National Insurance, setting the salary at the right level gives you entitlement to state pension and certain other benefits.
If you fail to run the payroll correctly then HMRC will impose fines. For example, a missed Real Time Information Return will incur a £100 fine each time it is missed. In reality that is £100 per month!
*Lower Earnings Limit
A business does not have to register with HMRC for payroll if it does not pay workers at an amount over what is referred to as the Lower Earnings Limit. Each year the amount of the Lower Earnings Limit changes. The up to date figure is available on the GOV.uk web site.
If you run your business on the side or have income from other sources then paying a salary from the company may not be the best approach unless you want to receive credits towards your future State Pension which you may not be receiving from elsewhere.
It’s worth noting that HMRC do not and cannot demand that a certain salary level is paid to a director. Nor is it true that paying a salary above a certain amount will avoid scrutiny by HMRC.
Dividends
Setting a salary at a tax efficient amount will probably not give you enough to live on. So, you’ll also need to pay a dividend to yourself from the company, if profits allow.
A dividend is an amount paid out to the shareholder(s) of a company. Only shareholders receive dividends although in a one person company the Director is often the single shareholder. When a dividend is paid from the business bank account it should be posted in your accounting system to the Dividends account.
If there is more than one shareholder, dividends should be paid separately to each shareholder on the same date in proportion to their shareholding even if the only other shareholder is a spouse. If you and your spouse are 50:50 shareholders, you should make a separate dividend payment to each of you of the same amount (50:50) on the same date. Do not lump dividends together even if you have a joint bank account.
Dividends are paid out of post-tax profits meaning that they are not an allowable cost for tax purposes and do not reduce your tax bill.
Dividends can be paid at any time although generally it is better to pay them monthly, quarterly or even annually if cashflow allows. Avoid taking weekly or ad hoc small amounts out as dividends.
When a dividend is paid, as well as the bank transaction, there are certain formalities which do need to be followed and cannot be re-created at a later stage. Technically the board of directors meet. They consider the financial position of the company and declare a dividend payment to the shareholders registered on the agreed date. Considering the financial position means checking if the company has sufficient funds to pay out a dividend – you need to work out the “profits available to distribute”. In reality this means carrying out a calculation to establish if there are sufficient profits to make a dividend payment.
Beware – this figure is not the same as the balance in the company bank account!
By far the simplest way to find this amount is from your accounting system where you’ll usually find the figure on your company dashboard. Without a system you’ll have to calculate the figure each time you want to declare a dividend meaning you’ll need to perform a calculation, explained below. It should become evident very quickly that if you operate a limited company then using an accounting system is much better!
It’s worth having an understanding of how the amount that you have available to take as dividends is calculated – the maths behind the figure in the dashboard.
Profits available to distribute as dividends calculation
Start by establishing the Company’s profits (Income less Costs = Profit)
From the profit take off:
• any dividends already paid in the current accounting year
• an estimate of the corporation tax due on the profit for the year using the current rate of corporation tax (see GOV.uk web site)
This will give you the profit for the year after the estimated tax:
Income less Costs = Profits less estimated corporation tax less dividends already paid in the accounting year
= Profits for the year available to distribute as a dividend
If you’ve been trading for more than a year you can add into this any profits that were brought forward from last year – you will find this in your accounts.
Profits for the year available to distribute + Retained Profits brought forward from previous year(s)
= Total Profits available to distribute as a dividend
Note – if this is a negative figure then there are no profits available to declare a dividend. So do not be tempted to take anything out of the company at this point remembering that this is not your money and you will be withdrawing money that belongs to the taxman!
If you do take more out of the business in dividends than is available this could result in significant issues later not least if you cannot settle your tax bill. HMRC could hold you personally liable for your tax removing the protection of limited liability that you would ordinarily have.
Whilst working out what is available to distribute as a dividend may sound like a faff, especially if you are the sole Director and Shareholder, the formalities exist to protect you from future questioning about the dividends. So following them is really important.
Getting Dividend Timings Right
Dividends can be declared at any time during the year although it is important to remember that dividends are reported on the self assessment tax return by Tax Year. This may be different to your company year.
A Tax Year for Self Assessment purposes runs from 6th April to 5th April each year
The key point to note is that the tax year starts on 6th April and ends on 5th April and not 1st April as some may think. Making a dividend payment on or after 1st April and before 6th April could mean a higher than anticipated tax bill if it pushes your overall income into the higher or additional rate tax bracket or over £100,000 where your personal allowance starts to reduce.
The Dividend Paperwork
When a dividend is taken out of the company there needs to be some formal paperwork to support this transaction. Of course many neglect this in a one person company and whilst the paperwork does have to be there the likelihood of anyone asking to see it is pretty minimal unless there is some wrong doing or the company falls upon hard times and ends up in liquidation.
If you do use accounting software some systems, such as FreeAgent, will automatically produce the dividend paperwork for you.
If not you can use a very simple template, such as the following.
Dividend Paperwork Template
Dividend Board Meeting Held On: [enter date] |
Directors Present: [enter name(s) of Director(s) |
Held at: [enter address where the meeting took place] |
At a meeting of the Board of Directors held on the above date, it was resolved that the company pay a dividend, set out below, to the shareholders of the company in proportion to their respective shareholdings. The shareholders have been advised of the amount. |
Dividend paid: [enter £amount] |
There being no other business the meeting was adjourned. |
Signed by Director: _____________________ |
Date of Meeting: _____________________ |
Payment Details |
Name of Shareholder: |
Dividend Amount: |
Date Paid: |
If you are in any doubt about your salary and dividends mix then this is an area where you’d pay an accountant to advise you each year, as well as help with setting up the payroll which, once you’ve grasped the basics, could be run by you through your accounting system.
Dividend Tax
When you’ve extracted money from your company you may have more tax to pay as Dividend Tax is due on dividends taken out of the company. The rates of dividend tax can be found, along with all other tax rates, on the GOV.uk web site – search for Dividend Tax.
The extra amount of tax due will depend on the level of your total income from all sources. Using an online dividend tax calculator, like the one on the IT Contracting web site will help you to keep an eye on how much income tax you need to pay.