Illegal dividends – how to avoid unlawful distributions

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, Patrick Gribben from InTouch Accounting explains how this can happen, and how to rectify an error.

What is an illegal (unlawful) 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 draw down a dividend illegally

If the company’s directors have declared an illegal dividend, it is not deemed to be a criminal offence – and you won’t be sent to prison as a result!

However, 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.

(Read the full guidance here, and further guidance in Manual CTM15205).

Dividend Waivers

The use of dividend waivers also gives rise to another potential pitfall for limited company owners.

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.