Illegal dividends and taking dividends from your company -refer ctm15205

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Introduction 

What are illegal dividends (HMRC) or unlawful dividends, and how do they arise when you’re UK contracting? Let’s take the time to consider when an illegal distribution may occur when you’re paying dividends from a limited company. In addition, let’s consider what you should think about when taking dividends from your company. This guide will cover how to take dividends from your private limited company, and we’ll research can I take dividends from previous years profits. We’ll also consider what is an illegal dividend and look at the guidance from CTM15205. Basically, CTM15205 is HM Revenue & Customs (HMRC) official guidance in this area.

Another term that we can use to describe contractor unlawful dividends is `ultra vires dividends.’ This is a Latin phrase which means `beyond the powers.’ It’s used in law to describe an act which requires legal authority but is carried out without it. Therefore, it exceeds the scope of power given to them by current laws.

When contracting and running your own company, as a director and shareholder, you’ll usually draw down profits occasionally. As part of profit extraction from your company, you may pay yourself a dividend from your business. On the other hand, you may receive your income as a salary. It’s key to note that Ltd company dividends are subject to tax but not National Insurance, unlike salaries. However, if you work through your own UK contractor limited company, a mix of salary and contractor dividends may be the best choice when you consider how to be tax-efficient.

Initial thoughts 

As a UK contractor, you may wonder how much you can pay yourself in dividends when you run your own company. The answer regarding how much dividends you can take for profit extraction is that there’s no limit. This is on the assumption that your company has enough profits available to pay the private company dividends you plan to take out. Therefore, as time passes, your business can go ahead and pay yourself dividends (UK) now and again. The UK dividends are payable to the company shareholders and are usually in line with their share ratios.

First thoughts on Illegal dividends (HMRC) 

How do we pay director dividends from post-tax realised profits? 

Private companies make dividend payments to their shareholders. Moreover, they pay these from the company’s post-tax realised profits. This means your company’s profit for the year after you deduct Corporation Tax. You may ask if I can take dividends from the previous year’s profits, and the answer is yes. Therefore, when considering limited company dividends, contractor available profits will include retained profits or losses brought forward from the previous set of annual accounts. Adding this together shows the total available, which you can pay as disbursements now. To summarise, the accumulated realised profits (or accumulated realised losses) plus the current year’s profit or loss, after allowing for any tax due, is the distributable profit available as UK dividends, as far as the company has the cash to do so.

When your limited company is paying yourself a dividend that is more than the sum of post-tax profits and any P&L balance brought forward from the previous year, we call this an illegal dividend or illegal distribution. Therefore, checking profit levels is essential to ensure enough funds are available before taking dividends from your company. If you have insufficient profits, you must wait until you generate more income before paying dividends.

The current rules about dividend payments are set out in Section 830 of the Companies Act 2006. This states, ‘ a dividend or distribution to shareholders may only be made out of profits available for the purpose.’

Other guides

Before we move on, there are several aspects to consider regarding how to pay yourself dividends. Therefore, when you’re a UK contractor taking dividends from a company, besides making sure you don’t draw more dividends than you’re entitled to, these additional aspects include:

  • How much dividend can I pay?                                                                                                                              
  • Illegal dividends (this guide).

Taking dividends from your company & when do they become illegal?

When should I pay private company dividends? 

You may ask how often I can take dividends from my company (UK). Indeed, there’s no right time to pay company dividends. You can draw these whenever and how often you like, provided sufficient profit exists. Most limited company contractors draw dividends from their business once per month or perhaps once a quarter

When you’ve got your own business, what paperwork or documents should a company paying dividends complete? Technically, in terms of paperwork for UK company dividends, you can create a dividend voucher. Moreover, you can do this each time you declare a dividend. You may ask, what are dividend vouchers? To explain, these are official documents that show the details of the dividend payments and are signed by a company director.

You can file the dividend tax voucher with your personal tax records. The voucher will then be available to show to third parties if needed. As a contractor, you’ll usually declare and pay the dividend simultaneously.

In real life, a third party isn’t likely to ask to see the dividends voucher. Therefore, you or your contractor accountant can prepare minutes of meetings at your company year-end. These will approve the limited company dividends you pay during the financial period. If you require dividend vouchers in the future, you can draw these up then.

Contractor illegal dividends & what happens when you overdraw? 

In most scenarios, taking dividends from your company is a simple process. However, you may, by accident, on occasion, overdraw private company dividends. As a result, some of these will, therefore, will be unlawful.

When you take more business dividends than are available in profit, the business’s financial position will show an overall loss. This loss is then, in effect, due to your contractor’s unlawful dividends. Therefore, you’ll be liable to repay the amount of illegal distributions in the future.

The Companies Act 2006 makes provisions for illegal dividends. Indeed, the Companies House Act 2006 states, “a dividend or distribution to shareholders may only be made out of profits available for the purpose”. Ross Martin has another good guide on this area and how the Companies Act 2006 relates to this.

Can I take dividends from previous years profits?

When trading, you may make an overall loss one year or another for various reasons. In this case, can you take dividends if you make a loss? When your company has some previous year’s profits still on the Balance Sheet, exceeding this year’s losses, the balance is available to pay as company dividends. However, as is always the case, it will depend on when the business has these funds as liquid cash, i.e., so far as the funds aren’t tied up in company assets such as fixed assets (car, computer equipment, etc) or investments.

It’s key to highlight that you only pay tax on company profits. Moreover, they’re taxed in the year the business generates these profits. Therefore, all company funds that haven’t been paid out as expenses, salaries, or distributed as dividends are distributable in the future.

The formula to use to avoid drawing too much dividends 

A limited company can prepare some management accounts or interim accounts to see the business’s current financial position. This exercise will show how much profit is in the business, and therefore, you will know what you can draw and avoid taking too much. However, there’s a quick and easy way to determine how much you can draw before you take a dividend from your company. Therefore, we show this in the formula below.

What is the actual formula?

The formula to use when paying yourself dividends from your company and calculating the maximum profit extraction is as follows:

Step 1 Take the sales in the current accounting year.
Step 2 Then, add together all of your business expenses and gross salary in the current accounting year.
Step 3 Next, take your expenses and gross salary in 2) above. Then, deduct these from the sales total in 1) above to arrive at a profit before Corporation (CT).
Step 4 Then, deduct CT from the profit figure in 3) above to arrive at a profit after CT. The CT is at 19% or 25%, depending on whether your company is small or large (please see our Corporation Tax guide for details).
Step 5 Take the profit or loss brought forward from the previous accounting year (as shown in the Profit and Loss account figure at the bottom of the Balance Sheet). We add this to the profit after tax figure in 4) above.

Result 

After step 5) above, the total you’ll arrive at is the distributable reserves currently in your business. This is the amount from which it can pay UK company dividends, provided there are the funds to do this, i.e., some funds that aren’t tied up in other assets, as mentioned earlier.

Another method 

You can also examine the company’s liquid assets, such as the bank account, instead of the above.

The next step is to deduct any company taxes due up to the present day from this. This will include any VAT yet to be paid, any PAYE/NIC due and any Corporation Tax on your company’s profit up to the present day. What’s more, you’ll deduct any other current creditors. Once you deduct these, you’ll leave an amount of cash in your business, which you can pay as business dividends. 

Further things to consider on unlawful distributions 

What should you do when you’ve taken illegal dividends? 

If your company makes an illegal distribution, you may have just been looking at your business bank balance and thinking there’s enough to cover bills. As a result, you may have forgotten to consider the business’s total bills and any monies your company owes. However, if you take too much dividends, it’s not a criminal offence. You will not receive any fines for this either. Instead, it’s a case that you didn’t take enough care. As a result, you must now research rectifying an unlawful dividend.

Your accountant will prepare your annual business accounts at the end of your financial year. At this point, it’ll become apparent if your business’s financial position is in the red due to overdrawing. If the business is in the red, your company may have paid too much director dividends. As a result, the overpaid dividend amount is put to your director’s loan account, and you must repay this to the company. When the reason for the company being in the red is down to taking too much UK dividends, and this overdrawing becomes a loan instead, you should aim to get any amount you owe repaid as soon as possible.

Therefore, if you’ve paid too much company director dividends and provided it was an interim dividend, the easiest way to rectify this is to repay the money you owe to your company as soon as you discover it. If you can’t currently do this, you can wait to see if future sales will generate enough income to create a profit again. Then, you can declare a dividend but don’t draw it from the company. Instead, the dividend is credited against the director’s loan account amount you owe due to the illegal dividend.

Contractor’s illegal dividends & what are the director’s duties? 

As a company owner, it’s essential to note that it’s one of your director’s duties to check what you can take as limited company dividends. You can use the formula above to check the company’s post-tax profits anytime. The overall profits available for company dividends are included after you include the profit and loss account balance brought forward.

If the business pays too much UK dividends in the year-end accounts, you’ll not go to jail for it. If this occurs, you can do a dividend reversal and convert those director dividends into a director’s loan instead, as explained earlier. After doing this, you must repay the director’s loan to the company. The sooner you repay this, the better it’ll be.

Therefore, as a director, you can check your business profit levels. You can do this before you pay any company dividends. If you can’t pay dividends now, wait until your business generates more profits. You can then recheck this position later.

Tax office guidance & the tax on overdrawn director loan accounts 

HMRC guidance on illegal dividends 

The tax office has further guidance for the above. You can find this in Manual CTM20090 and more details in Manual CTM15205.

Tax consequences of overdrawn director’s loan account -Section 455 Tax & P11D reporting

Your accountant will prepare your accounts when your company year-end comes around. At this point, you’ll know if your business has paid you too many dividends. If it has, your accountant must reverse the dividends. As a result, a reduced credit or overdrawn director’s loan account will show up in the company’s accounts instead.

As mentioned above, it’s 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, then one of the tax consequences of illegal dividends is that the business must pay Section 455 Tax. This tax is 33.75% of any overdrawn balance. Indeed, 33.75% is the same as the higher personal tax rate on dividends. Section 455 Tax is a temporary tax that is repayable to the company after you repay the director loan. Please note that although HMRC will refund the tax in the future, it’s a temporary hit on your cash flow.

The other tax consequence is that you may need to declare the overdrawn director’s loan on form P11D. We explain an overdrawn director loan account in more detail in one of our other guides, which covers a loan to a director.

If you ever find yourself in a position where your company can’t pay its taxes, this could be because you’ve paid too much in dividends. As a result, there will have been contractor unlawful dividends. Consequently, if you can’t see yourself meeting your company’s tax liabilities, there are certain things you must consider, including insolvency. In this scenario, your dividend payments will be scrutinised for legality by insolvency practitioners to determine what the director owes to the company due to excess drawings.

Final thoughts 

In this guide, we’ve considered what is an illegal dividend is and how it may arise. Indeed, when you’re taking dividends from your company, it’s not uncommon for the position of drawing too much to occur. Besides, many UK contractors who experience this won’t notice when illegal dividends occur until their accountant brings it up. Therefore, ensuring you don’t overdraw your dividends is essential, as this guide highlights.

When you work out what you can draw from your business, it’s important to remember the answer regarding can I take dividends from previous years profits. If you have existing profits or losses brought forward in your company from the previous accounts, your company’s previous total realised profits or losses should be noted. You will add these to the current year’s post-tax profits to learn what’s available for company profit extraction purposes and what you can draw.

Keeping your company’s tax savings in a separate account is a good idea when running your company. Therefore, you could put these into a company savings account. This is good advice and best practice for a UK limited company contractor. This way, the company’s tax savings are kept away from the regular funds in the Current account. When tax payments become due, you can transfer such amounts 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 business account, that’ll help ensure you don’t spend them.

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Published On: April 6th, 2024 / Categories: Dividends /

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