Illegal dividends -introduction
What are illegal dividends (HMRC) or unlawful dividends and how do these arise? Let us take the time to consider this. Let’s also consider what you should think about when you are taking dividends from your company. In this article we will cover how to take dividends and investigate can I take dividends from previous years profits. We will also consider what is an illegal dividend and how the guidance in CTM15205 fits in with this. Key to note, CTM15205 is HM Revenue & Customs (HMRC) official guidance in this area.
Another term which can be used to describe illegal or unlawful dividends is `ultra vires’. This in turn is a Latin phrase which mean `beyond the powers.’ It is 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 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 work through your own UK contractor limited company, a mix of salary and dividends may be the best choice when you consider how to be tax-efficient.
Initial considerations
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 in terms of taking dividends from your company. That is on the assumption your company has enough profits available to pay the dividend which you plan to take out.
Therefore, as time moves forward, your business may make payments of dividends now and again. The dividends are payable to the shareholders of the company. Moreover, the dividends are usually payable to the shareholders in line with their share ratios.
Illegal dividends (HMRC) -points of consideration
Pay dividends from post-tax profits
When private companies make dividend payments to their shareholders, they will pay the disbursements 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 yes. Therefore, you can take any profits brought forward into account when you calculate the total that is available that you can pay as dividends now. Therefore, the total accumulated realised profits (after you allow for any tax due) is the distributable profit that is available to pay as dividends, so far as the company has the cash to do so.
When a company pays a dividend and it is more than the sum of post-tax profits and any Profit and Loss account balance brought forward from the previous year, we call this an `illegal dividend.’ Therefore, it is essential to check your profit levels to ensure there are enough funds before taking dividends from your company. If you have insufficient profits, you will have 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 have to consider.
Other guides
Before we move on, there are many aspects to consider when you are a UK contractor taking dividends from your company. These include:
- The dividend allowance.
- 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 limited company 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 you declare a dividend. You may wonder what are dividend vouchers and to explain, this is an official document which shows the details of the dividend payment 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 (HMRC) -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, due to unlawful dividends. Therefore, you will be liable to repay this amount in the future.
The unlawful dividends Companies Act 2006 makes provisions for illegal or unlawful dividends. Notably, the Companies House Act 2006 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 paid 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 and this is in the year that the business generates these. Therefore, if all of those funds have not been paid out 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 draw when taking dividends from your company. 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 expensesand 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 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 that you can pay as dividends.
Illegal dividends -further things to consider
What should you do when you realise you have taken unlawful dividends?
If you do draw too much, it is probably the case that you may have just been taking a look at your business bank balance. Therefore, you may have forgotten 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 have to look into rectifying an unlawful dividend.
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 unlawful 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 should aim to get your company’s position back into the black as soon as possible.
If you have paid too much dividends, and providing 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 have 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 further 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 have to reverse these. As a result, a director’s loan account shows in the company’s accounts instead.
As we mention 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 unlawful dividends position to occur. Besides, many UK contractors who experience this will not happen to notice when this occurs. This is until their accountant brings it up for them. As a result, you will have 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. 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 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