Demystifying dividends: A guide for owner-managed businesses

As a business owner, understanding how to extract profits from your company is crucial to manage your finances effectively. One common method of distributing profits to shareholders in such businesses is through dividends. In this insight, we’ll cover dividends, explaining what they are, how they work, and why they might work for your business.

What Are dividends?

Dividends are payments made by a company to its shareholders out of its profits or retained earnings. They’re typically distributed in cash, but they can also be in the form of additional shares or other assets. Dividends represent a reward to shareholders for investing in the company and sharing in its success.

How do dividends work?

Understanding the mechanics of dividends involves a few key concepts:

1. Profit Generation: Before a company can pay dividends, it must generate profits. These profits are accumulated as retained earnings in the balance sheet.
2. Declaration: The company’s board of directors must declare dividends. This is a formal decision to distribute a portion of the company’s profits to shareholders. Not all profits need to be distributed; the board can decide how much to pay out.
3. Record Date: This is the date on which the company determines who its shareholders are. Only shareholders of record on this date will receive dividends.
4. Payment Date: On this date, the company actually distributes the dividends to the eligible shareholders, usually in the form of cash deposited into their accounts.

Why are dividends important for owner-managed businesses?

1. Income for Shareholders: Dividends provide a regular source of income to shareholders, which can be especially beneficial for business owners for their remuneration from the business.
2. Rewarding Shareholders: Dividends are a way to reward loyal shareholders who have invested in the company, showing them a return on their investment.
3. Tax Efficiency: In the UK, dividends are typically taxed at a lower rate than salary income. However, the dividend allowance has been reduced in recent years (now just £500 in 2024/25), which means tax planning is more important than ever when extracting profits through dividends. It’s vital to consider both personal tax and Corporation Tax when assessing overall efficiency.
4. Stability and Attraction: Offering dividends can make your business more attractive to potential investors, as it demonstrates a commitment to rewarding shareholders and can boost investor confidence.

Important considerations

While dividends can be a valuable tool for owner-managed businesses, it’s essential to consider a few key points:

1. Profitability: Before paying dividends, ensure your business is generating consistent profits and has enough retained earnings to support dividend payments.
2. Legal and Compliance: Dividends must be properly declared and supported by sufficient retained profits. It’s important to ensure dividend payments are legally declared and properly documented, HMRC and company auditors are increasingly focused on this area, and dividends made without adequate backing can be challenged or deemed unlawful after the fact.
3. Reinvestment vs. Distribution: Carefully evaluate whether it’s more beneficial to reinvest profits back into the business for growth or to distribute them as dividends.
4. Shareholder Agreements: If your business has multiple shareholders, ensure that you have a clear shareholder agreement in place that outlines the rules and procedures for declaring and distributing dividends.

Dividends are a valuable financial tool for owner-managed businesses. They provide a means to reward shareholders, offer a source of income, and can be tax efficient. However, they should be approached with careful consideration of your business’s financial health. You should seek advice from an accountant experienced in owner-managed businesses to help you make informed decisions regarding profit extraction through dividends.

Contact Ben Allman on ben.allman@ballardsllp.com or call 01905 794 504 for more information.

Disclaimer. This article has been prepared for information purposes only. Formal professional advice is strongly recommended before making decisions on the topics discussed in this release. No responsibility for any loss to any person acting, or not acting, as a result of this release can be accepted by us, or any person affiliated with us.