How Dividends Work

Dividends are company payments to shareholders from the profits made by that company. If you’re a business owner you’re probably wondering how dividends work for a small company? We’ll explain everything a small company owner/director needs to know about how dividends work.

How dividends work
Photo by Markus Winkler on Unsplash

What Are Dividends?

Dividends are payments by a company to the owners of that company. It is a reward and an incentive for shareholders to buy and continue owning shares in a company. A company can only pay dividends if it has sufficient profit reserves. That’s because dividends are the distribution of a company’s profit reserves to its shareholders. The word ‘dividend’ comes from the Latin word ‘dividendum’ which means something divided. The thing divided is the amount of company’s profit reserves that directors decide to pay. Shareholders receive their share of those profit reserves in the form of a dividend.

What are Profit Reserves?

Profit reserves consist of a company’s accumulated net profits, minus dividends paid to date. Retained profits, or the profit and loss account are other terms to describe profit reserves. The net profit of a company is its sales, minus its costs, minus any corporation tax payable on that profit. Adding this net profit to any opening profit reserves, then deducting any dividends, leaves the amount of closing profit reserves. This happens every year so that you have a running total of profit reserves.

A company must not pay a dividend if it doesn’t have enough profit reserves to cover that dividend. If it does, that dividend is unlawful. Shareholders and/or directors may need to return unlawful dividends back to the company.

Who are the Shareholders?

The total ownership of a company is divided into any number of shares. Shareholders are the people or entities (e.g. other companies), that own those shares of a company. For example a company may have a total of 100 shares. If so, each share would represent a 1% ownership of the company. The shareholders own a proportion of the shares that equal the proportion of the company they own. So if there was just one shareholder they would own all 100 shares or 100% of the company. Two shareholders could own anything between 50 shares each, or a split of 99 shares and 1.

This is a very simple example with one type and class of share, usually called Ordinary. A company can have a very complicated share structure with different classes and types of shares. For example it could have different classes of ordinary shares, such as A Ordinary and B Ordinary shares. It can also have different types of shares such as preference shares.

Directors do not receive dividends, only shareholders do. Shareholders appoint directors to run the company. A company can only pay a salary to directors, and only a dividend to shareholders. That’s how dividends work. However, in many small companies shareholders are also directors.

How much dividend does each shareholder receive?

Shareholders receive a share of the dividend in proportion to the number of shares owned compared to the total. Another way to put it, is that a company pays dividends at the same rate per share. So let’s say there are 100 shares in total, of which Mrs Smith owns 60 and Mr Jones owns 40. If the directors decide to pay a dividend of £10,000, that’s a rate of £100 per share (£10,000 / 100). So £6,000 (£100 x 60) is payable to Mrs Smith and £4,000 (£100 x 40) is payable to Mr Jones.

How dividends work in practice? Part 1

The procedure and advice on how dividends work in practice is as follows: 

  1. First you need to check that you have sufficient retained profit to cover the total dividend. Retained profit is the net profit (after salaries and tax) since the company started. Minus the dividends since the company started. If your accounting is up to date, you can use the Balance Sheet report to find retained profit. Look for Total Equity (minus shares) or Retained Profit or Profit & Loss.
  2. Each shareholder receives a proportion of the total dividend. The same proportion as the number of shares held by each shareholder compared to the total.
  3. It’s a good idea at this point to check the personal tax consequences. A personal tax year ends on 5th April. So a 5th April dividend goes on that tax year’s personal tax return. A 6th April dividend (the day after) goes on the following tax year’s personal tax return. The first £2k of dividends received by an individual in a tax year (5th April) are tax-free. You pay 8.75% tax on dividends in your basic tax rate band (up to total income of about £50k). You pay at least 33.75% tax on any dividends that fall into a higher tax rate band. The current dividend tax rates are here.

How dividends work in practice? Part 2

  1. If you are happy to proceed, you can then either physically pay the dividend with a bank transfer. Or credit it to a loan account by making an accounting adjustment. This would be a manual journal or an expense to dividends using the shareholders loan account. Crediting a dividend rather than paying it will either reduce the amount the shareholder owes to the company. Or increase the amount the company owes to the shareholder. If you are repaying a loan owed to the company, wait 30 days before making any further payments. A payment to the shareholder within 30 days effectively cancels out the loan repayment. Payments to the shareholder from the loan account do not normally have any further tax consequences.
  2. You also need to create documentation as evidence of each dividend, consisting of board meeting minutes and a dividend voucher. We can provide a form to automatically create the paperwork on request (clients only).
  3. Dividends can’t be backdated. However, if you are just catching up with the paperwork for dividends decided earlier, it should be ok.

If you have any other questions about how dividends work, let us know. Our clients receive advice like this included in all of our fixed fee accountancy packages.