One of the main methods small company owners use to remunerate themselves (and other shareholders) is by distributing profits via dividends.
The way dividends are administered is straightforward enough, but what happens if you declare a dividend only to discover that there were insufficient profits at the time to justify such a payment?
What is an illegal / unlawful dividend?
This happens more often than you might imagine, typically as a result of the company director(s) making a decision based on the company’s bank balance instead of actual profits and/or not checking the accounts properly.
Unfortunately, simply admitting you made an honest mistake isn’t good enough – at least not as far as HMRC is concerned. They take the view that as a director it’s your responsibility to make sure there are enough profits in the company accounts before declaring a dividend. If this is found not to be the case, they can declare the dividend illegal.
It’s not a criminal offence as such (see below), but illegal dividends can be reclassified as salary and you’d be liable for income tax and national insurance contributions on the amount.
Ultra Vires – two words you don’t want to hear
The term HMRC uses to describe an illegal dividend is ‘ultra vires’ which literally means ‘beyond the powers’. As stated above this is used when the company had insufficient profits to justify a dividend being declared at the time. Put another way, they didn’t have the right – or power – under current tax laws, to pay a dividend.
A dividend can also be deemed illegal if you fail to complete a board meeting minute of the dividend decision as you are required to do by the Companies Act.
Something else worth noting, especially if you diversify your business, is that as a director you are expected to act in the best interest of the company at all times, including protecting company assets. If, by paying a dividend, you are judged to be jeopardising the company or its assets, such dividends could also be declared illegal.
How to avoid illegal dividends
By keeping management accounts accurate and up to date, it will be easier to calculate profits and avoid declaring unjustifiable dividends. This is where having a good accountant can definitely help, or you can invest in some accounting software to help make life easier.
Either way, if all business transactions are recorded accurately on a spreadsheet you’ll be able to see a breakdown of the company’s finances, including profits and tell whether or not you can pay a dividend.
Another way of arriving at the same point is to subtract your expenses, including salary, from revenue. Make allowances for any VAT or PAYE liabilities owed to HMRC, and then deduct 19% for corporation tax – the figure you’re left with is profit.
Rather than taking full profits, however, it’s advisable to leave some in place for any adjustments that need to be made at year-end.
What’s important to note, is that by keeping a record of your calculations you’ll be able to show that the company was in profit at the time you declared a dividend.
Correcting an illegal dividend
As a director of the company, you’ll find it hard to prove you didn’t know the dividend was illegal at the time. HMRC holds you fully responsible for any decisions made.
If you have paid an illegal dividend, the simplest way to put this right is to repay the company the money. If this isn’t possible, because you’ve already spent the money, for instance, you may be able to wait until the business is in a profitable position again.
HMRC manual 20090 provides guidance on how to repay an illegal dividend.
As we’ve already pointed out, declaring an illegal dividend is not a criminal act in itself but any attempt to rectify the situation by backdating dividend vouchers, calculations, board minutes or other relevant documents would definitely be considered a criminal offence under the Companies Act.