Are you taking illegal dividends?

Published: 29/08/2018

For many small owner managed businesses dividends are a tax efficient way for the owner manager to be remunerated. It is common to see such companies paying their owner managers a small notional salary, usually in line with income tax personal allowances, supplemented by regular, often monthly dividends. This is tax efficient because there is a saving for the company which does not pay employers NIC on the dividend and there is a saving for the recipient as tax on dividends is lower than PAYE.

However, this approach to remuneration can be extremely risky when trading conditions are less favourable. The Companies Act 2006 states that a “company may only make a distribution out of “profits available for the purpose”.  Profits available for the purpose are the accumulated, realised profits less accumulated, realised, losses. Dividends may not be paid out of capital or from a revaluation reserve or a share premium reserve. If a company that does not have sufficient profits available for the purpose pays a dividend to its shareholders that dividend will be illegal or “ultra vires” which means beyond the purpose.

In the event that the Company enters into Administration or Liquidation any illegal dividends will have to be repaid. In such cases the recipient of the dividend will often say “but that is what my accountant told me to do”. This is not a defence and the Liquidator/Administrator will still want the dividend to be repaid. Even if a company has distributable profits available there are a number of legal requirements that must be followed to make a dividend legal. These must be completed at the time that the dividend is declared or paid:

  • Accounts must be drawn up on a proper accounting basis showing that the company has sufficient distributable profits to pay the dividend
  • A meeting of the shareholders must be held to authorise the payment of the dividend. This meeting must be minuted, even if there is only one shareholder.
  • The minutes must show that the shareholders have properly considered the effect of the dividend on future viability of the Company. If the dividend leaves the company in such a weakened financial position that it is vulnerable to collapse then the Liquidator may seek its repayment.
Most small business owners do not realise the risks of taking dividends from financially weak companies. They continue taking the same payments that they have always taken and rely on their accountant to tidy up the paperwork at year end. If however the company becomes insolvent during the year and the proper paperwork has not been completed this leaves them vulnerable to being asked to repay dividends taken.

To protect themselves directors/shareholders should ensure that they do the right things at the right time to record and justify any dividends that they take.