Dividends – Legal and Illegal

Written by Shakeel Butt on 28 September 2018

One of the benefits of operating through a limited company is that it gives the owner managed company an opportunity for the director/shareholders to extract profits out of the company tax efficiently.

Taking profit as a dividend distribution instead of a salary via the company payroll is one method, due to the lower tax rates on dividends.  In addition, the first £2,000 of all dividends received in a tax year is free of tax (prior to the 2018/19 tax year it was the first £5,000).   In addition to income tax, salary payments above certain limits, are subject to Employer and Employee national insurance contributions.

The table below summarises the different tax rates ignoring national insurance contributions

Band Tax on Salary Tax on Dividends
Within the basic rate 20% 7.5%
Higher Rate 40% 32.5%
Additional rate 45% 38.1%

 

Each individual’s circumstance is different and generally for the smaller company, a combination of a modest salary to cover the annual tax-free personal allowance coupled with dividend is a favoured approach.

Legal dividend

The timing of the dividend payment needs to be carefully considered and the Companies Act 2006 sets out what profits are available for distribution by dividend and what accounts are required to justify a dividend. If the requirements are not met than the dividend is unlawful and therefore illegal.

In summary; no profit, no dividend. A company can only make a legal dividend out of available distributable profits, which are accumulated realised profits less any previous accumulated losses (if any).  A provision for corporation tax provision also needs to be provided, so only after-tax profits are available for distribution.

It follows that before a distribution is made, the directors must ensure that the company has available distributable reserves, and this is usually by reference to the last annual accounts and preferably interim accounts which are more up to date and offers greater confidence in establishing the legality of the dividend.  If dividends are distributed without these calculations and checks, they could be deemed illegal if there are insufficient reserves available to cover them.

Other conditions to be met before a dividend is considered lawful are:

  • A board meeting should be held to consider the level of the ‘distributable profits’ available and to declare a dividend. Minutes of the meeting should be kept.
  • A divided voucher should be prepared and issued to all recipients of the dividend.

Here at WSM we constantly educate our clients about the dividend rules and procedures. Based on our experience, miscalculation of profits and poor record keeping can occasionally lead to the payment of illegal dividends if up to date information of the company’s financial position is unreliable or not available. At WSM, for those clients who we prepare the annual statutory accounts, we usually plan to start the accounts around three months after the financial year end.  As part of the process, we check the validity of the dividends that have been declared. We encourage clients not to delay in providing us with the accounting records, so we can identify this or any other potential issues and problems. It is always advantageous to pick up problems at an early stage. Where we prepare management accounts etc than we can pick up issues and problems earlier. Where we come across illegal dividends, or where it is borderline we discuss and try and resolve the situation. Educating clients is an ongoing process to minimise problems.

Unlawful dividend

It is the director’s responsibility to be fully aware of the financial position of the company and to ensure all dividend distributions are legal. Under the Companies Act 2006, the recipient of an unlawful dividend may be required to repay the amount.

Dividends deemed illegal by HM Revenue & Customs may be reclassified as a salary on which income tax and national insurance becomes due. Therefore, if you take a regular dividend, you need to ensure the company profits can support a payment on each occasion.

For directors, the dangers of declaring unlawful dividends increase considerably if a company becomes insolvent (this is where the liabilities are more than assets) particularly and where the dividend payments caused the company’s financial decline. In situations where a formal liquidation is necessary, part of the liquidator’s role is to scrutinise any payments to shareholders during the years leading up to the insolvency, with a view to identifying illegal transactions such as dividends with possible serious consequence for the directors.

In summary, whilst dividends offer an opportunity to pay lower tax, it is very important to ensure they are legal, and the formalities are completed. For profitable and successful companies, we discuss and put in place a profit extraction strategy in line with the long-term objectives of the company.

If you would like to discuss further, please contact Shakeel Butt. shakeel@wsm.co.uk  or  0208 545 7624

Shakeel Butt Profile
Shakeel Butt
Private and Corporate Client Director