In most cases, extracting profits from a company by distributing dividends to shareholders is a simple process. But what happens if you mistakenly declare dividends which are greater than the value of the company’s available profits?
Here, Patrick Gribben from 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. In other words, 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 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 or Ultra Vires dividend, as dividends should only be paid from profits.
A director has a responsibility to check there are sufficient profits before a dividend is declared. This process can be as simple as checking your management accounts – or consulting your accounting software (see below).
What happens if you draw down a dividend illegally
If the company’s directors declare an illegal dividend, it is not a criminal offence – and you won’t go to prison as a result!
However, if you fail to take reasonable care – by not preparing management accounts to check profits before declaring a dividend – then you may be responsible for repaying the dividend to the company.
If you have already 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 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.
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 receive income, and others don’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.
Use accounting software to minimise the risk
You will always know precisely what your tax and accounting position is – massively reducing the chance of making a mistake.
This isn’t a silver bullet, however. as your accounting position is only ever as accurate as the data you have input in the first place.
Make sure all of your bank statements, invoices and anything else are up-to-date before working out your retained profit.
If you have any doubts at all – talk to your accountant!
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