One of the main benefits associated with becoming a private limited company is the ability to take money out of the company in a more tax efficient way. While the profit made by soletraders and partnerships is taxed as income, the owners and directors of limited companies typically pay themselves a small salary (equal to the tax-free personal allowance of £11,000) and take the rest as dividends.

In order to declare a dividend legitimately and benefit from these tax advantages, it’s essential to ensure the money exists in the company as profit in the first place. Secondly, you must make sure you record the details of the declaration accurately. Tick both of these boxes and there’s no risk of falling foul of HMRC.

What paperwork needs to be completed?

To make a legitimate dividend declaration, the board of directors first needs to pass an ordinary resolution of the members and record it in the company records. You must also provide each shareholder with a dividend voucher to show the number and type of shares held, along with the dividend amount and the tax credit.  

Dividends can only be paid from retained profit

Section 830 of the Companies Act 2006 states that: ‘a company may only make a distribution out of profits available for this purpose’. Some directors and limited company contractors make the mistake of overpaying dividends by declaring them based on the company’s bank balance, rather than profits. When corporation tax is then taken into account at the end of the year, they find their profits have reduced and the level of dividends they’ve paid actually creates a loss.

It is the director’s responsibility to check there are sufficient profits in the company before declaring a dividend. Failure to do so could result in what is known as an ‘Ultra Vires’, or illegal dividend.

What happens if an illegal dividend is declared?

If you fail to check there are sufficient profits in the business before declaring a dividend, you risk paying out more money than the company has in retained profits, and subsequently creating a loss. The result is that you will be trading while insolvent and your director’s loan account will become overdrawn.

A director’s loan occurs when you take money out of your company that isn’t a salary, dividend or expense repayment, and isn’t money you’ve previously loaned or paid into the company. Any money you borrow or pay into the company must be recorded in a ‘director’s loan account’. If a director’s loan account becomes overdrawn, any money that remains unpaid is treated as an outstanding loan, and this can create tax complications for both the company and its director.

If you fail to take reasonable care in declaring the dividend, there’s also the risk that the Ultra Vires dividend declaration will lead to an HMRC investigation, payment penalties, and even the dividend being recategorised as salary. It will then be subject to additional income tax and National Insurance contributions.   

What happens if the company becomes insolvent?

If a dividend has been paid unlawfully and the company becomes insolvent, there is a very real risk that the recipient(s) of the unlawful dividend will become personally liable for the repayment. Even if the overpayment of the dividend was accidental, HMRC will argue that it is your duty as a director to be aware of the company’s financial position at all times.

When insolvency and the payment of unlawful dividends are combined, directors will face pressure to explain their actions on both counts. For this reason, if you are approaching insolvency and have an overdrawn director’s loan account resulting from unlawful dividends, you should seek professional advice.    

What should you do next?
The good news is that declaring an illegal dividend is not a criminal offence. If you have paid an illegal dividend, the easiest way to rectify the situation is to repay the money as soon as you can. However, if you are unable to do so and fear the company has become insolvent, you should get in touch with our team of insolvency practitioners for the expert assistance and free advice you need.