What are dividends? A comprehensive guide

As a small business owner with a limited company, you’re an employee, a director and a shareholder all rolled into one. This unique position gives you the flexibility to pay yourself a combination of salary and dividends. 

While a salary is straightforward, dividends offer a tax-efficient way to extract profits from your company. But they come with their own set of rules and tax implications. Understanding how they work is key to optimising your income and keeping your business on a solid financial footing. 

In this guide, we’ll dive into dividends for small business owners, covering everything you need to know about dividend tax, allowances and the all-important decision of how to pay yourself. 

What are dividends?

A dividend is a payment a limited company can make to its shareholders from its retained profits. Unlike a salary, which is paid to you as a director for your work, a dividend is a distribution of the company’s post-tax profits. 

Before a company can pay a dividend, it must first pay all its business expenses, liabilities, and Corporation Tax. The money that remains (the distributable profits) is then available to be paid to shareholders. Dividends are typically paid in proportion to the number of shares each shareholder owns. So, if you own 100% of the company’s shares, you are entitled to 100% of the dividends. 

It is illegal to pay dividends if your company has no retained profits, and doing so can lead to serious consequences, including personal liability for the illegal dividend. Therefore, proper record-keeping and a clear understanding of your company’s financial health are essential. 

What is the annual tax-free Dividend Allowance?  

The Dividend Allowance is a tax-free amount of dividend income you can receive each year, in addition to your Personal Allowance. For the 2025-26 tax year, this allowance is £500.  

This means that the first £500 of dividend income you receive is completely tax-free, regardless of your other income. While it has been significantly reduced in recent years, it remains a useful part of a tax-efficient strategy. 

How do you calculate the tax payable on dividends? 

Calculating dividend tax depends on your total income for the year, which includes your salary, any other income (such as rental income) and your dividends. 

For the tax year 2025-26, the process works as follows: 

Work out your total taxable income

Add up all your sources of income, excluding your Personal Allowance (£12,570 for most people) and your tax-free Dividend Allowance. 

Determine your tax band

Your total income will place you into one of the following tax bands: basic rate, higher rate, or additional rate. 

Apply the dividend tax rates 

Once you’ve used up your Personal Allowance and the tax-free Dividend Allowance, your dividends will be taxed at the following rates: 

How much can I pay myself in dividends? 

There is no limit to the amount you can pay yourself in dividends. However, as mentioned, your company must have enough profit after all expenses and Corporation Tax have been paid. If you pay more than your available profits, it is an illegal dividend, and HMRC can demand the money back, potentially with penalties. 

It is important to note that every time you declare a dividend, you must hold a directors’ meeting (even if you’re the sole director), keep minutes of the meeting and issue a dividend voucher. This voucher is a vital record for both the company and your personal tax affairs. 

How often should you declare dividends?

Unlike a salary, which is usually paid monthly, there are no strict rules on how often you can declare dividends. You can choose to do it: 

• Monthly to provide a regular stream of income, like a salary 

• Quarterly or annually, which can be easier for administration as it aligns well with other tax deadlines 

• On an ad-hoc basis, whenever your company has sufficient retained profits and cash flow. 

What is a dividend waiver? 

In a company with multiple shareholders, dividends are usually paid to all shareholders in proportion to their shareholding. However, a dividend waiver is a legal document where one or more shareholders voluntarily give up their right to receive a dividend. 

This is most used in family-owned businesses where one shareholder may not need the income (for example, a retired parent), allowing a higher dividend to be paid to a working spouse or child who may be in a lower tax band. 

A dividend must be used for a valid commercial purpose. HMRC is vigilant about waivers used solely for tax avoidance. The waiver must be a formal deed, signed before the dividend is declared. It is highly recommended to seek professional advice before proceeding with a dividend waiver.

Is it better to pay yourself a salary or dividends? 

This is one of the most common questions for a small business owner, and the answer is usually a combination of both. 

The classic strategy is to pay yourself a low salary and top it up with dividends.  

A salary is a tax-deductible business expense. This means your company can deduct the cost of your salary from its profits before calculating Corporation Tax, effectively reducing the company’s tax bill. In contrast, dividends are paid from the company’s profits after Corporation Tax and are not a tax-deductible expense. 

A significant advantage of dividends is that they are not subject to National Insurance Contributions (NICs) for either the employee or the employer. This can lead to substantial tax savings compared to a high salary, which is subject to both employee and employer NICs. 

It is also important to consider tax rates. While salaries are taxed at higher Income Tax rates, dividends are taxed at the lower dividend rates.  

It is a good idea to pay yourself a salary, at least up to the National Insurance Lower Earnings Limit (£6,500 for 2025-26) to ensure you qualify for National Insurance credits, which count towards your State Pension and other benefits. 

For these reasons, the most tax-efficient strategy for many limited company directors is to pay a small salary and then take the rest of your income as dividends. 

How One Two One Accounts can support your business

Dividend tax is a specialist task and getting it wrong can be costly. This is where the right accountancy partner can make all the difference. 

At One Two One Accounts, we specialise in providing proactive, personalised and jargon-free support to small businesses like yours. 

Here’s how we can help you with your dividend strategy: 

• We’ll work with you to determine the most tax-efficient combination of salary and dividends, ensuring you maximise your take-home pay while staying fully compliant with HMRC rules

• We’ll handle the necessary documentation, including preparing dividend vouchers and keeping accurate records, for complete peace of mind

• Our team are always ahead of game and are committed to keeping up to date with the latest tax legislation and can provide you with tailored advice that helps you legally minimise your tax liability

• We offer proactive support and advice well ahead of a tax deadline, so we can help you monitor your company’s financial health and ensure you always have sufficient retained profits before declaring dividends. 

Dividends offer a powerful tool for tax-efficient profit extraction from your limited company. By understanding the rules around documentation, allowances and tax rates, you can structure your income in a way that minimises your overall tax burden. 

As an accountancy that offers a personalised service and specialises in supporting SMEs, our team are here to help you make the best decisions for your business and personal finances, ensuring your business remains compliant and financially sound. Contact us for a free consultation.