The main method company owners use to draw down business profits is by distributing dividends to the company’s shareholders. In most cases, this is a simple process, but what happens if you mistakenly declare dividends which are greater than the value of your available profits?
Here, Clare Rickman, director of client services at InTouch Accounting, explains how this can happen, and how to rectify an error.
What is an illegal dividend?
A company can declare a dividend if it has sufficient profits available, that being an excess of sales over expenses and taxes. Sadly it’s not unusual for contractors to accidentally overpay dividends by declaring them based on the company bank balance rather than profits, and without them checking management accounts for profit levels first.
When Corporation Tax is then calculated at the year end the available profits reduce, and the dividend that was paid suddenly creates a loss. This is known as an illegal dividend, or Ultra Vires, as dividends should only be paid from profits.
A director has a responsibility to check there are sufficient profits before a dividend is declared, and that can be as simple as checking your management accounts.
What happens if you drawn down a dividend illegally
Declaring Illegal dividends is not a criminal offence, so you won’t go to jail because of them. If you failed to take reasonable care though, say by not preparing management accounts to check profits before declaring a dividend, then you may be responsible for repaying that dividend to the company.
If you have paid an illegal dividend then, provided it was an interim dividend, the easiest way to rectify it is to simply repay the money to the company. If you cannot do so then you can wait to see if future sales will generate enough income to create a profit position again.
HMRC has provided some technical guidance supporting the repaying of an illegal dividend.
Technical guidance to correct an illegal dividend declaration
HMRC manual CTM20090 states:
‘Frequently the dividend is found to have been paid unlawfully. If that is the case, the company’s advisors will be able to rectify the situation by reducing or extinguishing the amount of the dividends and drawing up approved accounts showing only such amount of dividends as can be supported by distributable profits. Corresponding adjustments will be made to directors’ loan accounts, if the dividends have been credited to such accounts in the company’s books, or in draft accounts.’
Another potential dividend-related pitfall you should be aware of involves the use of dividend waivers.
There may be occasions where some shareholders waive their rights to receive income from a dividend distribution. This means that some shareholders will receive income, and others won’t.
There may be legitimate commercial reasons why you would elect to waive a dividend, but in many cases, these arrangements are made for tax avoidance reasons – often between spouses.
Find out what a dividend waiver is, and why you should be aware of the Settlements Legislation.