How to avoid unlawful (illegal) dividends as a company director

In most cases, extracting profits from a company by distributing dividends to shareholders is straightforward.

But what happens if you mistakenly declare dividends that exceed the company’s available profits?

This guide 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 retained profits available in its accounts.

In law, dividends may only be paid out of distributable profits, which are accumulated realised profits less accumulated realised losses under section 830 of the Companies Act 2006.

It is not unusual for contractors to accidentally overpay dividends by declaring them based on the company’s bank balance rather than profits, without first checking management accounts or their accounting software for profit levels.

When Corporation Tax is calculated at year-end, available profits decline, and the dividend paid suddenly results in a loss.

This is known as an illegal or ultra vires dividend, as dividends should only be paid from profits that have been generated. The terms illegal, unlawful and ultra vires all describe the same situation in this context.

A director has a responsibility to check that there are sufficient profits before declaring a dividend.

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The burden of proof lies with the directors to show that profits existed at the time of declaration.

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 will not go to prison as a result.

However, if you fail to take reasonable care, for example, by not preparing management accounts to check profits before declaring a dividend, then you may be liable for repaying the dividend to the company.

If you have already paid an illegal dividend, the general expectation is that it should be repaid to the company, whether it was an interim dividend or a final dividend. Repayment is the cleanest way to restore the company’s position.

If you cannot do this immediately, you may have to wait until future sales generate enough income to return to a profitable position.

In the meantime, the unlawful dividend is often reclassified as a loan to the director.

If this loan is not repaid within nine months of the company’s year-end, a Section 455 Corporation Tax charge of 32.5% of the loan amount can apply until it is cleared.

HMRC has provided some technical guidance supporting the repayment of an ultra vires 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 in CTM20090, and further guidance in Manual CTM15205.)

Dividend waivers

The use of dividend waivers also presents another potential pitfall for limited company owners.

There may be occasions when some shareholders waive their right to receive dividends. This means that some shareholders receive income, and others do not.

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.

Use accounting software to minimise the risk

Consider using accounting software, such as the widely used FreeAgent, to clearly display your retained profits at any time.

You will always know precisely what your tax and accounting position is, which massively reduces the chance of making a mistake.

This is not a silver bullet, 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.

Additional notes from the IT Contracting team

To reinforce the guidance above, here are a few practical points and references for small company directors to note.

• Distributable profits, not cash at the bank. Company law allows distributions to be made only out of distributable profits. Cash balances on their own do not prove that profits exist. See the ICAEW TECH 02/17 guidance for details.
• Capital maintenance and solvency still matter. Directors must consider whether later losses or liabilities would turn a proposed dividend into a return of capital. Professional bodies emphasise applying the capital maintenance rule when approving dividends.
• Repayment is the most effective remedy. In practice, unlawful dividends are often reclassified through the director’s loan account until repaid. Leaving a loan outstanding can trigger additional tax under s.455 if it is not cleared within nine months after the accounting period end
• Shareholder knowledge is relevant. Where recipients knew or should have known a dividend was unlawful, repayment may be required. See analysis from law firms such as Osborne Clarke on remedies and consequences.
• A short example. The bank shows £20,000. You pay a £10,000 dividend. Year-end adjustments recognise £8,000 Corporation Tax and £4,000 other creditors, leaving only £8,000 of distributable profits. The excess of £2,000 is unlawful and should be repaid or treated as a loan to the company until it is cleared.
• Avoid common pitfalls. The ACCA highlights frequent errors, including relying on draft figures, overlooking tax provisions and ignoring interim accounts when switching GAAP. The theme remains the same: use reliable management information before declaring a dividend.

If in doubt, prepare up-to-date management accounts and take advice from your accountant before declaring a dividend. It is much easier to avoid a problem than to unwind one later.