Illegal dividends and taking dividends from your company -refer ctm15205

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Illegal dividends -introduction 

What are illegal dividends and how do these arise? Let us take the time to consider this and what to think about when it comes to taking dividends from your company.

When you are contracting and  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 contractor 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 salary and dividends may be the best choice when you consider tax efficiency.

As a UK contractor, when you run your own company, you may wonder how much can you pay yourself in dividends. The answer with regard to how much dividends can I take is there is no limit providing your company has enough profits available to pay the dividend which you plan to take out.

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

Illegal dividends -considerations 

Paying dividends from post-tax profits 

When private companies make dividend payments to their shareholders, they will pay this from the company’s post-tax profits. This means your company’s profit for the year after you deduct Corporation Tax. You may ask can I take dividends from previous year’s profits and the answer is you can take any retained profits brought forward into account when you calculate the total that is available to be paid as dividends. Therefore, the total accumulated realised profits (after you allow 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.

When a dividend is paid by a company and it is more than the sum of post-tax profits and any Profit and Loss account balance brought forward from the previous year, it is called an `illegal dividend.’  Therefore, it is essential to check your profit levels to ensure there are enough funds to make dividend payments. If you have insufficient profits, you need to wait until you generate more income before you make dividend payments.

The current rules about 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.

Other guides

Before we move on, there are many aspects to consider when you are taking dividends from your company. These include:

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

When should I pay dividends? 

You may ask how often can I take dividends from my company. There is no right time as such 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 can create a dividend voucher each time a dividend is declared. You may wonder what are dividend vouchers and to explain, this is an official document which shows the details of the dividend paid and is signed by a director of the company.

You can file the dividend voucher with your personal tax records. The voucher will then be available to show to third parties if the need arises in the future.

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 that you pay during the financial period. If you require dividend vouchers in the future, you can draw these up then.

Illegal dividends -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 are available in profit, the business’s financial position 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 provisions for illegal or unlawful dividends. It states, “a dividend or distribution to shareholders may only be made out of profits available for the purpose”.

Can I take dividends from previous years profits?

When you are trading you may make an overall loss one year or another for a variety of reasons. In this case, can you take dividends if you make a loss? When your company has some previous year’s profits that are still on the Balance Sheet then these can be distributed as dividends in the future. This will, however, depend on when the business has these funds as liquid cash i.e., so far as the funds are not tied up in company assets such as fixed assets (car, computer equipment, etc) or investments.

It is important to highlight that company profits are only taxed once in the year that they are generated. Therefore, if all of those funds have not been consumed as expenses, salaries, or distributed as dividends then they will be distributable in the future.

The formula you can 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. However, there is a quick and easy way to calculate how much you can take as dividends. We show this in the formula below.

The actual formula

  • Take the sales in the current accounting year.
  • Then, add together all of your business expenses and gross salary in the current accounting year.
  • 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).
  • Then, deduct CT at 19% from the profit figure in 3) above to arrive at a profit after CT.
  • The final step, take the retained profit that is brought forward from the 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 currently in your business, from which it can pay dividends.

Alternative method 

Instead of the above, you can look at the company’s assets that are of a liquid nature, such as the bank account.

The next step is to deduct from this any company taxes that are due up to the present day in time. This will include any VAT yet to pay, any PAYE/NIC that is due and any Corporation Tax on your company’s profit up to the present day. You will also deduct any other creditors at this point in time. Once you deduct these, it will leave the amount of cash in your business available to be paid as dividends. 

Illegal dividends -further considerations

What should you do when you draw too much? 

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

What’s more, if you do draw too much, it is not a criminal offence. Nor will you receive any fines for this. Instead, 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 annual business accounts at the end of your financial year. At this point, it will become clear if your business’s financial position is in the red due to excess dividends. If the business is in the red, you may find that 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 need to get your company’s position back into the black.

If you have paid too much dividends, provided it was an interim dividend, the easiest way that you can rectify this is to 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.

Illegal dividends -director’s duties 

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

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

Therefore, as a director, you can check your business profit levels. You can do this before you pay any dividends from your business. If you cannot 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 -illegal dividends 

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

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

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 around. 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. As a result, a director’s loan account shows in the company’s accounts instead.

As we mentioned above, 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 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, which is repayable to the company after you repay the director loan. Please note that 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 cover a loan to a director.

Final thoughts -illegal dividends 

It is not uncommon for the `illegal dividend’ position to occur. Besides, many contractors who experience this will not happen to notice when this occurs. This is until their accountant brings it up for them. You will need to report the dividends you draw on your tax returns; therefore, it is important to ensure you do not draw any illegal dividends, as we highlight in this article.

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

When tax payments 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 will help make sure that you do not spend them.

Link to Contractor Advice UK group on

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Published On: August 1st, 2022 / Categories: Dividends /

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