What are dividends, and how can small businesses use them?

While large, publicly traded organizations that pay dividends may do so once or twice a year, smaller businesses may choose to pay them more often, depending on the founders’ requirements. Privately held, single-shareholder companies, for instance, may decide to pay dividends every month — as this can be more tax-efficient for the owners than receiving a salary.

On the other hand, startups and growing companies usually do not declare dividends, as any profits made are put back into the business. So, how do dividends work? Are there rules about paying dividends?

Below is your guide to understanding dividends and how they work in a small business setting.

Understanding dividends

What are dividends? At its simplest, dividends reflect the portion of earnings not reinvested in a business in a given year but paid out to owners and shareholders. 

Better said, dividends are payments —  a portion of the profits — made by an organization to its shareholders. They are usually paid in the form of cash, but sometimes companies may also choose to pay dividends in the form of stock or other assets.

How do dividends work? While an organization, through its board of directors, has the power to choose when to pay dividends, the frequency of payouts is usually in order with profit announcements, typically quarterly, semi-annually or annually. Besides, businesses can choose to pay additional dividends if more profit was made in that year too.

To further understand the working of dividends, let’s consider the example of Groover Winery, a family-owned business that produces quality wines and has a policy of paying annual dividends to its shareholders. It reports $200,000 of gross income in 2023 and with deductions totaling $100,000, the company is left with $100,000 in taxed profits. The board of directors has decided to pay out dividends on the net profit of $100,000 to its shareholders.

John holds 1000 shares in Groover Winery and is ought to receive dividends as illustrated below.

Scenario 1: Cash dividends are paid: Cash dividends are paid using the company’s earnings, and given out on a per-share basis.

When Groover Winery declares a dividend of $0.20 per share, John will receive $200 (0.20 X 1000) as dividends for being an investor in the company.

Scenario 2: Stock dividends are paid:  This involves companies giving shareholders additional shares as dividend payouts, on a per-share basis or a percentage. The shareholders would not be paid in cash but will receive more earnings if the company grows in future profits.

Instead of cash, Groover Winery decides to pay a 5% stock dividend. This means investors will receive 0.05 shares for every share they own in the company. Hence, John would get 50 additional shares for every 1000 shares he owns. 

Why do organizations pay dividends? Organizations decide to pay dividends for a number of reasons. While for some, dividends are one way to keep investors investing in their company, for many others, consistent dividend payments are a way to indicate their long-term viability. 

How much do companies pay in dividends? Dividend payments vary widely. It is contingent on profits; the more profitable a business is, the more it will potentially pay in dividends. Remember that the board of directors decides whether and when to pay the dividend, and what amount. 

Plus, it is important to note that each class of shareholder receives the same amount of dividend, pro rata, for the number of shares they hold.

Do all companies pay dividends? Not every company pays dividends. Most commonly, mature companies pay regular dividends as they’re well-established, profitable and growing slower. Think of businesses operating in mature industries such as energy, consumer staples and industrials, the ability to generate more cash than it needs to grow helps these organizations pay dividends.

However, sometimes even large profitable companies — despite generating strong cash flow and being highly profitable — may choose to hang onto the funds and reinvest them in the company to expand further seeking top-line growth. 

Below are some examples of large organizations that don’t pay dividends:

Alphabet Inc. Despite its piles of cash, this Google parent firm has never paid a dividend to its shareholders. The firm instead uses its available capital to generate high growth through acquisitions and to invest in internal businesses, such as Google’s effort to expand its data center footprint.

Amazon Inc. Being in its “hypergrowth” phase, the world’s largest online retailer uses its cash reserves to acquire other firms or invest in its own businesses, such as Amazon’s one-day shipping service.

Meta Platforms Inc. Despite being among the Top 10 in the S&P 500, this social media giant hasn’t paid out any dividends and is unlikely to do anytime soon.

Smaller companies that expand quickly typically won’t make dividend payments. That’s because it’s fiscally shrewd to reinvest the cash back into operations during pivotal growth stages.

That said, there are some small, private businesses that choose to extend dividends to reward their shareholders or simply to reduce the tax liability of the owners.

Below are some examples of small, private businesses that pay dividends:

New Belgium Brewing. The Colorado-based craft beer company is 100% employee-owned and has a policy of paying dividends to its employee-owners.

Borgen Systems. A small engineering and manufacturing company based in Minnesota and in business for over 40 years, Borgen has a policy of paying out a portion of its profits to its shareholders in the form of dividends.

Vino Farms. A family-owned vineyard management company based in California. It manages over 16,000 acres of vineyards and has a policy of paying dividends to its shareholders.

Continental Carbonic Products. A manufacturer and distributor of dry ice and liquid carbon dioxide based in Illinois. The business is privately held and has a history of paying dividends to its shareholders.

John’s Crazy Socks. This New York-based small online retailer sells unique and fun socks. The company is family-owned and has a policy of paying dividends to its shareholders.

Note: Dividend-paying businesses may suspend dividends if they’re experiencing some sort of financial trouble, like declining revenues or an expensive lawsuit.

How can small businesses use dividends?

Put simply, organizations pay dividends to share profits with the shareholders, giving out any excess profit not needed for the business. However, if done right, small businesses can reap more benefits by choosing dividend payouts. 

Here’s a deeper look at how small businesses can use dividends.

To reward existing investors. If a small business is organized as a corporation and has shareholders, it can choose to pay out a portion of its profits as dividends. This can be a way to reward investors and maintain their loyalty. 

To attract more investors. Not every investor likes to play the long game, many seek recurring income from their investments regardless of what happens with their share price. And dividends can be an excellent way of attracting such investors.

To signal good financial health. Having enough funds to pay dividends could indicate to investors that the company they’re investing in is doing well and has a long-term viable business model.

To manage their cash flow. By giving out a portion of their profits as dividends, small businesses can reduce the amount of cash they have on hand, which can be useful if they are looking to invest in new projects or pay off debt.

To reduce the owner’s taxes. Under the right circumstances, having a dividend payout policy can result in a hefty potential deduction from your earnings as a small business owner. Opting to pay yourself a reasonable salary and regular dividends over the year, you can significantly lower your overall tax liability. Plus, it will help reduce your chances of being questioned by the IRS.

However, in order for this salary-dividend strategy to be most effective, your corporation should be an S corporation. A regular C corporation is required to pay corporate-level tax on amounts it pays out as a dividend and thus wiping out the possibility of any overall savings. 

Let’s consider the above example of Groover Winery. As the sole owner-shareholder of the business, instead of taking the net profit of $100,000 as salary, you decide to receive a $20,000 dividend and $80,000 in salary. 

As the sole proprietor, your entire net business income of $100,000 will attract a self-employment tax. However, if you own an S corporation business, only your salary component of $80,000 would attract self-employment tax. And the second component of your income would come to you as distribution, which is not taxed. Thereby reducing your overall tax liability. In short, opting to pay dividends helps you save on your taxes. 

Involving so many items and reporting requirements, adding a dividends payout policy can complicate your already cumbersome business tax returns filing process. Opting for outsourced accounting can ensure proper accounting of dividends and business tax compliance.

Conclusion

Small businesses should be cautious when using dividends, as they can be a significant expense and may not be sustainable in the long term. Before implementing a dividend policy, small businesses should carefully consider their financial position, their future growth prospects, and the needs and expectations of their shareholders. It may also be advisable to seek the advice of a financial professional. 

Small business dividends FAQs

Can I pay dividends if my company isn’t in profit?

No, you can’t pay dividends if your firm doesn’t make a profit. However, you can reduce the capital of your company in order to create a distributable reserve to declare dividends.

Are there any specific rules about paying dividends?

The most important rule to remember about paying dividends is that an organization can only declare a dividend if it’s profitable. Figure out if you are eligible to make a dividend payout by calculating your profits net of corporation tax, that is the amount left after taxes and expenses have been subtracted. 

Besides, make sure that all shareholders of the same class receive the same amount of dividend. 

What is the necessary paperwork to declare a dividend?

Provided you have enough profit to declare a dividend, you need to call a meeting of the directors wherein the amount to be paid as a dividend is declared. Make sure to record the decision within the minutes of the meeting.  

Next, you’ll have to prepare a dividend voucher and send it to each shareholder for retention either electronically or as a hard copy.  The dividend voucher is required to include the following information: date; company name and number; shareholder name and class; the number of shares held; amount paid per share; dividend paid.

Do small businesses need to pay tax on the dividend?

Dividends are paid after all expenses have been deducted from the profits of the organization, and that includes corporation tax. So, the company doesn’t need to pay tax on the dividend as it has already paid taxes on its earnings. However, the shareholders are required to pay income taxes on their dividend earnings. To get a better understanding of the taxation of dividends, read here.

What is the journal entry for paying dividends?

The journal entry to record the declaration of the cash dividends entails a decrease (debit) to retained earnings account (a shareholders’ equity account) and an equivalent increase (credit) to dividends payable (a liability account). To learn about the correct journal entry of stock dividends, read here.

How often are dividends paid by companies?

Most businesses that pay a regular dividend do so quarterly, although you can choose to pay dividends monthly, biannually or annually. Remember that it is the board of directors that determines the declaration of dividends including its timing and amount.

This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage please contact us here.

Author

Kanika Sinha

Kanika is an enthusiastic content writer who craves to push the boundaries and explore uncharted territories. With her exceptional writing skills and in-depth knowledge of business-to-business dynamics, she creates compelling narratives that help businesses achieve tangible ROI. When not hunched over the keyboard, you can find her sweating it out in the gym, or indulging in a marathon of adorable movies with her young son.