IT Contractor Accountants - Accounting - Accounts

Derek Kelly of ClearSky Accounting takes a look at the rise in illegal dividends reported in recent months, and how limited company contractors should take care when making dividend declarations.

Sharp rise in illegal dividends

HMRC has been turning its attention on what it calls the sharp rise in the number of allegedly illegal dividends and director loans drawn by the owners of limited companies in recent weeks.

HMRC is one of the largest unsecured creditors to insolvent firms and the sudden targeting of illegal dividends is largely due to the fact that HMRC is concerned that unlawful dividends mean that company directors are not paying the full amount of tax that they should. The trend seems to have arisen from an increase in the number of insolvency cases due to the recent economic climate.

Figures from the Insolvency Service show that 2,169 directors of insolvent companies faced disqualification in the year to March 2010, a 17 per cent increase on the previous year. As part of the insolvency process, practitioners have been uncovering a number unlawful dividends or loans made to directors, hence HMRC's attack on the practice.

Illegal dividends to avoid 50% tax rate

Another reason cited is the recent increase in the highest rate of income tax to 50 per cent, which came into effect in April this year. Some company directors are using illegal dividends in an attempt to avoid this.

With this in mind, I thought it might be useful to revisit what constitutes an illegal dividend and there are two ways that a dividend becomes unlawful.

When does a dividend become "illegal"?

The first is when the corresponding paperwork is incorrect, and this is another reason why contractors should always consider working with a specialist contractor accountant. We would always advise contractors to consult their accountants when drawing up the paperwork for their dividends.

The second reason that a dividend is considered illegal is unfortunately the most common and it is when their dividend is paid without the sufficient amount of profit in the business to substantiate the amount. The payment of a dividend such as this effectively means that the company is now trading insolvently and is therefore considered to be breaking the law. In cases such as this, HMRC has the power to reclassify the dividend as a director's loan.

Advice for contractors

To avoid this, we recommend that contractors only make the decision on how big a dividend to award shareholders once the company accounting information is up to date and the dividend can be accurately calculated on the most up to date amount of profit the business has generated.