Tax on dividends is levied at a different rate to tax charged on other forms of income. Company directors can use this discrepancy to lower their tax bills.

What are dividends?

Dividends are payments made to shareholders of a company. Many companies choose to retain some of their annual earnings and re-invest them in the company, while paying the remained to shareholders. This payment is the dividend.

Instead of paying yourself a salary, you might choose to pay yourself dividends. These are taxed at a lower rate than regular income.

How are dividends taxed?

Dividends are taxed at two different rates. The rate at which you are taxed will depend on whether your dividend income is above or below the basic Income Tax limit. This is set at £37,400 for the 2009-10 tax year.

• Dividend income up to £37,400 is taxed at 10 per cent. This is called the dividend ordinary rate.
• Dividend income above £37,400 is taxed at 32.5 per cent. This is called the dividend upper rate.

As you can see, this can represent a significant tax saving if you choose to pay yourself through dividends rather than salary. However, you should note that this is only possible if you are working outside the scope of IR35.

How do I pay myself dividends?

If you wish to pay yourself through dividends you would be well advised to seek the help of an accountant. They will be able to tell you how much you can sensibly withdraw in this way, and guide you through the process.

However, there are a few broad principles that you should remember.

• You cannot pay yourself more in dividends than your company has made in the year after corporation tax.
• Dividends can only be paid after a board meeting. You must do this even if you are the sole director. This is likely to mean having a one-person meeting and drawing up minutes. You must also issue dividend receipts, also known as dividend counterfoils. Your accountant will be able to help you with this.
• HMRC will demand to see this documentation. If you do not have it, your dividend income will be treated as regular income for tax purposes. HRMC has the power to look back at dividend income for the previous six years – so it is vital that you properly document any payments from the beginning.

It cannot be stressed enough – if there are any ‘procedural’ or paperwork errors in your dividend payments, you risk being landed with a hefty tax bill. Seek the advice of a good accountant from the outset.