In this article we take a look at what a “dividend” actually is, who can pay a dividend and who can receive it – as well as lots of other considerations that you need to think about.
But most importantly, we take a look at exactly how a dividend should be recorded in Xero… which Xero account should you use, and why? This is certainly one part of the bookkeeping that you want to get right! Let’s get started…
What is a "dividend"?
A dividend is an amount of money that is paid out of a company’s profits to its Shareholders. A dividend paid to a Shareholder is classed as investment income and must normally be included on their personal self-assessment tax return (UK).
What types of business can pay a dividend?
Most Limited Companies that have issued share capital can pay out dividends. This includes Private Limited Companies (LTD) and Public Limited Companies (PLC). Most small, family-owned companies are Private Limited Companies.
Self-employed businesses (Sole Traders and Partnerships) can’t pay dividends as they do not have a corporate shareholding structure. Neither can Limited Liability Partnerships (LLP) for the same reason.
Who can be paid dividends?
Shareholders, that therefore hold share certificates in a company, are normally able to receive dividends from the company. There is generally no obligation for the company to pay dividends to Shareholders unless there is a provision in the company’s statutory records which states that dividends must be paid under certain conditions.
There is no minimum or maximum age for the Shareholder receiving dividends. However, there is UK tax legislation in place which regulates the tax treatment involved when paying dividends to children.
It is possible that shares in a company can be held by other companies too. Therefore, dividends can also be paid to other companies.
It is important to note that a Director of a company is not necessarily a Shareholder. A Director is a company officer who generally oversees the day to day operations of the company. A Director does not own any part of the company unless they also hold shares in the company. Therefore, if a Director is not also a Shareholder, then they cannot be paid dividends by the company.
Do all Shareholders have to be paid dividends equally?
Generally, Shareholders that hold the same class of shares in a company must be paid equally in proportion to the number of shares they each hold.
Sometimes, it is agreed that certain classes of shares are not eligible to be paid dividends, or the amount payable differs to other classes of shares.
“Alphabet Shares” are commonly used to enable the company board to vary the amount of dividends payable to each class of Shareholders. This can be a great way of distributing profits to different Shareholders based upon their investment in/contribution to the company – through differing rates of dividend.
“Dividend Waivers” can sometimes be used by Shareholders to forego their dividend payment whilst other Shareholders of the same share class are still paid their dividend. However, Dividend Waivers can only be used in very specific circumstances.
It is important to note that, in the UK, there is legislation in place to ensure that companies do not use Alphabet Shares and Dividend Waivers in order to artificially manipulate and minimise the rate of tax payable on dividends by connected persons.
How often can dividends be paid?
There are no rules regarding how often dividends can be paid to shareholders. Some companies pay dividends monthly, some quarterly, some annually and some never at all. The decision is completely down to the Board of Directors.
However, it must be noted that where companies (particularly small companies) pay dividends extremely regularly (e.g. monthly), HM Revenue & Customs (HMRC) may argue that the dividends are in fact being paid in lieu of salary (especially where salary is being paid to the Shareholding Director at a rate lower than market value for the position). In such a circumstance, HMRC would seek to tax the dividend income as employment income (normally at a higher rate of income tax than would be paid on dividends).
What documentation do I need to create as evidence of the dividend?
Dividend Vouchers must include the following information:
- Date of the dividend
- Name of the company
- Names of the Shareholder(s) being paid the dividend
- Amount of dividend being paid
Important: If the above dividend documentation is not in place for each dividend paid then, upon review, HMRC will likely disregard the dividend transaction. Instead the amount paid would need to be reclassified as a loan to each Shareholder – which will normally result additional tax being paid by the company.
What is an “Illegal Dividend”?
An “illegal dividend” (i.e. a dividend which has been unlawfully issued) is one which has been paid when cumulative profit reserves are not high enough to cover the amount being paid.
Note: The amount of cumulative profit reserves available has little to do with the amount of cash held in the company’s bank account(s) at the time. It is in fact an accounting calculation which we will look at shortly.
Where a dividend is deemed to be “illegal”, the Shareholder(s) receiving payment must pay back the unlawfully paid element of the dividend to the company (i.e. the amount paid in excess of the level of cumulative profit reserves).
How much dividend can I pay myself?
There is a calculation which is needed to be made in order to calculate the maximum level of cumulative profit reserves available to be issued as a dividend. It is as follows:
Available Profit Reserves brought forward (after adjusting for any amount of corporation tax payable on prior year profits)
Add: Current Accounting Year Profits to date
Less: Corporation Tax Liability accrued during the current accounting year to date
Less: Dividends already paid during the current accounting year to date
Equals: Profit Reserves available to issue as a dividend (maximum dividend amount)
Here at Xenon Connect, we recognise that having to calculate this figure every time that you want to pay yourself a dividend can be tedious and complicated. That is why our dashboard integrates with your Xero bookkeeping data and automatically calculates the maximum amount that you can pay to Shareholders as a dividend at that current point in time (assuming your Xero data is up to date of course!).
Why does it matter which Xero account I use?
If you categorise a dividend payment to Shareholders incorrectly within Xero then it is extremely likely that the reports that you run off within Xero will show incorrect information too.
The most common dividend mistake made by Xero users is that they post dividend payments to an expense code (for example, a code in “Overheads”), which results in the dividend reducing the net profit figure for the year in the Profit & Loss report. The problem with this is that it is implying that the company will get corporation tax relief on the dividend payment – which it should not!
Which Xero account should I use for dividends paid?
It may surprise you to learn that, currently, Xero does not include a dedicated account code for Dividends in the default chart of accounts.
Therefore, an account code needs to be created in your Xero to record dividends properly. But not just any code! It must be given the correct account type in the chart of accounts.
The account type that you need to use for the new account is “Equity”.
Here are the steps to create a Xero account code for Dividends:
- Within Xero, click on your company name (on the top bar) until a drop-down menu appears.
- Select “Settings”.
- Select “Looking for advanced settings?” at the bottom of the screen.
- Select “Chart of accounts”.
- Click “Add Account” button.
- Select “Equity” in “Account Type” drop-down menu.
- Choose an unused account “Code” (we recommend “965”).
- Give the account a “Name” (we recommend “Dividends”).
- Ensure that the “Tax” drop-down menu shows “No VAT”.
- Tick to “Enable payments to this account” (this will allow you to use the Dividends account when explaining bank payments in Xero).
- Click “Save”.
Your “Dividends” account is now ready to use.
Do I need to create a separate dividend account in Xero for each Shareholder?
No. You do not have to create a separate dividend account in Xero for each Shareholder. One dividend account is enough. However, if creating multiple dividend accounts makes it easier for you to see who has and hasn’t been paid dividends, then there is nothing stopping you doing so.
If you do create multiple dividend accounts in Xero, just make sure that you go through the same process above – perhaps using the next available account code each time (e.g. 965, 966, 967 and so on). It would also make sense to include the Shareholder’s name in the account name.
How do I record a dividend in Xero if it is not yet paid?
Sometimes, the company declares a dividend (holding a board meeting and creating the necessary documentation) on a day which is earlier than when the dividends are transferred to the Shareholders’ bank accounts.
This is common for larger companies, but it can also be useful to do so for small companies. For example, when a dividend is intended to be effective in a certain financial year for tax purposes but doesn’t need to be physically paid in cash until the next financial year.
In order to record this scenario correctly in Xero, there is an slightly different process that should be used to record the dividend declaration and the actual cash payment to Shareholders.
An accounting “journal” will need to be created in Xero to register the creation of the dividend and recognise that it is payable to Shareholders but has not yet been paid.
The process to go through is as follows:
- Within Xero, click on the “+” button (on the top bar) until a drop-down menu appears.
- Select the “Manual journal” option.
- Write an appropriate “Narration” to describe the journal (something like “Declare dividend payable to Shareholders”).
- Enter in the correct “Date” for the effective date of the dividend (per the supporting documentation that you create).
- Enter a “Credit” value (i.e. the value of the dividend being declared) in the first line of the journal using an appropriate account code with Type “Liability”. If all of the Shareholders are also Directors of the company, then you could use their “Directors’ Loan Account” (which is Xero code 835 by default). You may instead choose to create a separate Xero account code as appropriate (Note: Make sure that you set the new account code as Type “Liability”).
- Enter a “Debit” value (for the same amount in the second line of the journal. You should use the account code that you previously created for “Dividends” (see further up the article if you have not done this yet).
- Click “Post”.
The dividend payable has now been recorded correctly in Xero.
All that is left to do is record the payment of the dividend correctly when it leaves the company bank account in the future.
To do this you should explain the bank payment to the Shareholders with the Xero account code “Directors’ Loan Account” (or whichever liability account you used in the first line of the journal above).
This will tell Xero that the dividend payable to Shareholders has now been paid.
Are there any Xero tools that make dividends easier?
Yes! In fact, we have made the tool ourselves here at Xenon Connect.
Our simple but powerful Dashboard for Xero users integrates with your Xero account and calculates what is the maximum amount that your company can pay out in dividend (based upon your bookkeeping data).
Within just 2 minutes, you can have this information in front of you – as well as lots of other really great features. It really is that easy. Certainly worth a free trial right?