Illegal dividends

Introduction 

What are illegal dividends? Let’s take a look into this.

If you run your own company, as a director and shareholder, you will usually draw down profits from time to time. When you do this, you may take dividends from your business. On the other hand, you may receive your income in the form of a salary. However, if you are a contractor, a mix of both salary and dividends may be the best choice, when you think of tax efficiency.

Therefore, as time moves forward, your business may pay dividends now and again. These are payable to the shareholders in the company. What’s more, the dividends are payable to the shareholders in line with their share ratios.

Considerations   

Paying dividends from post-tax profits   

When private companies make dividend payments to its shareholders, these should be paid from its post-tax profits. This means your company’s profit for the year after the deduction of Corporation Tax. However, any retained profits brought forward can also be taken into account. Therefore, the total accumulated realised profits (after allowing for any tax due) is the distributable profit that is available to be paid as dividends, so far as the company has the cash to do so.

If a company happens to pay dividends that are more than the sum of post-tax profits and any Profit and Loss account balance brought forward from the previous year, they are called `illegal dividends.’  Therefore, it is important to check your profit levels to ensure there are enough funds to make dividend payments. If you have insufficient profits, you will need to wait until you have generated more income before you make dividend payments.

The current rules with regards to the payment of dividends are set out in the Companies Act 2006. This states “a dividend or distribution to shareholders may only be made out of profits available for the purpose”.

If you ever find yourself in a position in the future where your company cannot pay its taxes, this could be a result of taking too much as dividends and there are certain things that you need to consider.

Now, before we move on, there are many aspects to paying dividends. These include:

  • Illegal dividends (this article).

When should I pay dividends?     

There is no `right time’ for your business to pay dividends to you. You can draw these whenever and how often you choose, providing there is sufficient profit. Most contractors will take their dividends once per month or perhaps once a quarter.

In terms of the paperwork for dividends, technically, you should create a dividend voucher each time a dividend is declared. This dividend voucher can be filed with your personal tax records. The voucher will then be available to show to third parties in the future, should the need ever arise.

As a contractor, you are likely to declare and pay the dividend at the same time.

In real life, a third party is not likely to ever ask to see the dividend vouchers. Therefore, you or your accountant can prepare minutes of meetings at your company year-end. These will approve the dividends paid during the financial period. If, by chance, you require dividend vouchers in the future, you can draw these up then.

When you draw too much 

In most scenarios, when you take dividends from your company, this is a simple process to perform. However, you may, by accident, on occasion take too many dividends.

When you take more dividends than is available in profit, the financial position of the business will show an overall loss. This loss is then, in effect, an `illegal dividend.’ Therefore, you will be liable to repay this amount in the future.

The Companies House Act 2006 makes provision for illegal or unlawful dividends. It states “a dividend or distribution to shareholders may only be made out of profits available for the purpose”.

The formula you can use to avoid drawing too much dividends     

A limited company could prepare some management accounts or interim accounts to see the current financial position of the business. However, there is a quick and easy way for you to work out how much you can take as dividends. We show this in the formula below.

The actual formula   

  1. Take the sales in the current accounting year.
  2. Then, add together all of your business expenses and gross salary in the current accounting year.
  3. Next, deduct your expenses and gross salary in 2) above from the sales total in 1) above, to arrive at a profit before Corporation Tax (CT).
  4. Then, deduct CT at 19% from the profit figure in 3) above, to arrive at a profit after CT.
  5. The final step, take the retained profit that is brought forward from previous accounting year (as shown in the Profit and Loss account figure at the bottom of the Balance Sheet). Add this to the profit after tax figure in 4) above.

Result

After step 5) above, the total that you will arrive at is the distributable reserves that are currently in your business, from which it can pay dividends.

Alternative method

Instead of the above, you could look at the company’s assets such that are of a liquid nature, such as the bank account. The next step would be to deduct from this any company taxes that are due up to the present day in time. This would include any VAT yet be paid over, any PAYE/NIC that will be due and any Corporation Tax based on your company’s profit up to the present day. You would also need to deduct any other creditors at this point in time/ Once you have deducted these it will leave the amount of cash in your business that is available to be paid as dividends.

Further considerations  

What should you do when you draw too much? 

If you do draw too much, it is common that you may have just been taking a look at your business bank balance. Therefore, you may have failed to take into account the business’ total bills and any monies that your company owes out.

What’s more, if you do draw too much, it is not a criminal offence. Nor will you receive any fines for this. Rather, it is a case that you did not take enough care. As a result, you will now need to put this right.

Your accountant will prepare your business annual accounts at the end of your financial year. At this point, it should become clear if your business’s financial position is in the red, due to excess dividends. If the business is in the red, your company may have paid too much dividends.

When the reason for the company being in the red is down to taking too much dividends, you will need to get your company’s position back into the black.

In the event that you have paid too much dividends, provided it was an interim dividend, the easiest way that you can rectify this it is to simply repay the money to your company as soon as you discover this. If you cannot currently do this, you can wait to see if future sales will generate enough income to create a profit position again.

Director’s duties

It is important to note, as a company owner, it is one of your director duties to check what you take as dividends. You can use the formula above to check what the company’s post-tax profits are at any time. The overall profits that are available for dividends are after taking into account the Profit and Loss account balance brought forward.

If the business does end up paying too much dividends in the year-end accounts, you will not go to jail for it. In the event that this occurs, you should convert those dividends into a director’s loan. After doing this, you will need to repay the director loan to the company at a future point in time. The sooner that you repay this, the better it will be.

Therefore, as a director, you should take care and check your business profit levels. You can do this before you pay any dividends from your business. If you are not currently able to pay any dividends, you should wait until your business generates more profits. You can then recheck this position at a later date.

Tax office guidance and tax on overdrawn director loan accounts

HMRC guidance   

The tax office has detailed guidance that covers the above. You can find this in Manual CTM20090. You can also find more info on this in Manual CTM15205:

1   https://www.gov.uk/hmrc-internal-manuals/company-taxation-manual/ctm20090

2   https://www.gov.uk/hmrc-internal-manuals/company-taxation-manual/ctm15205

Section 455 Tax   

Your accountant will prepare your accounts when your company year-end comes round. At this point, you will know if your business has paid you too much dividends. If it has, your accountant will need to reverse these. A director loan account will then show in the company’s accounts instead.

As mentioned, it is best to repay any director’s loan account as soon as possible. Ideally, you should repay this within nine months of your company year-end. If you repay this after nine months, the business will be required to pay Section 455 Tax. This tax is 33.75% of any overdrawn balance. Indeed, 33.75% is the same as the personal tax higher tax rate om dividends. Section 455 Tax is a temporary tax, and it is repayable to the company after you repay the director loan. Please note, although HMRC will refund the tax in the future, it is a temporary hit on your cash flow.

We explain Section 455 Tax and overdrawn director loans in more detail in one of our other articles that covers a loan to a director.

Final thoughts

It is not uncommon at all for the `illegal dividend’ position to occur. Besides, many contractors who do experience this, will not happen to notice that this has occurred. That is until their accountant brings it up for them. The dividends that you draw will be reported on your tax returns therefore it is important to ensure that you do not draw any illegal dividends as highlighted in this article.

When you run your own company, it is best practice to keep your company’s tax savings in a separate company savings account. This way, they are kept away from the regular funds in the Current account.

When tax payments then become due, you can make transfers back to the Current account and make the payments to the tax offices. Therefore, if you always aim to keep your company tax savings in a separate company account, this helps make sure that you do not spend them.

Link to Contractor Advice UK group on 

LinkedIn    https://www.linkedin.com/groups/4660081/

Published On: March 2nd, 2021 / Categories: Dividends /

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