Limited companies can only pay dividends from profits which are available for distribution.
If your company pays out more than it can legally support, the excess is usually described as an unlawful dividend.
This can happen surprisingly easily in a small company. You might take dividends during a profitable few months, only for a large expense, unpaid invoice or Corporation Tax bill to leave the company with less profit than expected.
An unlawful dividend needs to be dealt with properly, but it does not automatically mean that you have committed a criminal offence.
What happens next depends on how much was paid, what the company’s accounts showed at the time and whether the money needs to be repaid.
What is an unlawful dividend?
Under section 830 of the Companies Act 2006, a company can only make a distribution from profits available for that purpose.
In practical terms, this means the company must have enough accumulated realised profits, after taking account of accumulated realised losses, to support the dividend.
Having enough cash in the company bank account is not the same thing as having enough profit to pay a dividend.
For example, some of the cash in your account may be needed to pay VAT, PAYE, suppliers or Corporation Tax.
Similarly, £20,000 received through a business loan may increase your bank balance by £20,000, but it does not create £20,000 of profit which can be paid out as dividends.
The company needs to have sufficient distributable profit when the dividend is paid.
The figures should also be supported by suitable company accounts. These may be your latest annual accounts or, if they are out of date, more recent interim or management accounts.
HMRC provides more detail on the accounts which can be used to justify a distribution.
How do unlawful dividends happen?
There are several common reasons why a limited company ends up paying too much in dividends:
- you take dividends based on the company bank balance rather than its actual profits;
- you forget to allow for Corporation Tax or other unpaid liabilities;
- you use an estimated profit figure which turns out to be too high;
- you continue taking the same monthly dividend after company income falls;
- the company has losses brought forward from an earlier year; or
- dividends are paid without checking up-to-date accounts.
This can easily happen when directors take a regular amount from the company each month and treat part of it as a dividend. Our guide to the salary and dividend split for directors covers the usual payment arrangements.
There is nothing wrong with paying interim dividends during the year. However, the directors need reasonable evidence that sufficient distributable profits exist each time a dividend is declared.
A simple example
Your company has £20,000 of distributable profits available.
You pay yourself dividends totalling £25,000.
If there were no further profits available to support the payments, the company has paid £5,000 more than it was legally able to distribute.
It is the £5,000 excess which causes the problem. The whole £25,000 does not automatically become unlawful simply because the company paid too much.
For more on how dividends normally work, see our guide to limited company dividends and tax.
Is an unlawful dividend the same as an illegal dividend?
You will sometimes see the terms ‘illegal dividend’ and ‘unlawful dividend’ used to describe the same thing.
Unlawful dividend is usually the better term.
Paying one does not automatically mean that a director has committed a criminal offence. It means that the payment was made without satisfying the company law rules which apply to distributions.
That still needs to be corrected.
There can be much more serious consequences if directors knowingly remove money from a company which cannot afford it, falsify records, mislead creditors or continue extracting funds when the company is insolvent.
Does an unlawful dividend have to be repaid?
It may do.
Under section 847 of the Companies Act 2006, a shareholder can be required to repay an unlawful distribution if they knew, or had reasonable grounds to believe, that the distribution was unlawful.
This is an important point for small limited companies because the shareholder receiving the dividend is often also a director.
As a director, you are likely to have access to the company’s accounts and know its financial position.
An outside shareholder in a much larger company may be in a different position if they had no realistic way of knowing that the dividend should not have been paid.
Do not assume that an accidental dividend can simply be left as it is.
Your accountant should establish how much of the dividend was unsupported, when it was paid and how it should now be treated.
What should you do when you discover an unlawful dividend?
First, stop paying further dividends until you know how much distributable profit the company actually has.
Your accountant will usually need to look at:
- the annual or interim accounts available when the dividend was paid;
- profits or losses brought forward from previous years;
- the date and amount of each dividend;
- board minutes and dividend vouchers;
- the company’s bookkeeping records; and
- your director’s loan account.
If only part of a dividend was unsupported, your accountant can separate the valid dividend from the unlawful amount and correct the accounting records accordingly.
Do not backdate dividend paperwork to try to fix the problem.
Board minutes and dividend vouchers record what actually happened. Creating new paperwork later cannot create distributable profits which did not exist when the payment was made.
Repaying the money
One option is for the shareholder to repay the unlawful amount to the company.
HMRC’s guidance on unlawful dividends explains how repayments and loan account entries may be dealt with.
Repaying the money does not mean that you erase the original transaction from the records.
The company should keep a proper record showing what was paid, why the problem arose and what was done to correct it.
Using the director’s loan account
If you do not repay the money immediately, the amount may instead be recorded as money you owe to the company through your director’s loan account.
This can create another set of tax issues.
If a loan to a director-shareholder remains outstanding more than nine months after the end of the company’s Corporation Tax accounting period, the company may have a section 455 tax charge to pay. Our director’s loan calculator can help estimate the charge.
There can also be a taxable benefit if the amount you owe the company exceeds £10,000 and you do not pay interest at HMRC’s official rate.
See the Government’s director’s loan guidance for more information.
If the company later makes sufficient profits, it may be possible to declare a new dividend and credit that dividend against the loan account.
However, the company must have enough distributable profits when that new dividend is declared.
A profitable few months later cannot go back in time and make the original dividend lawful.
What are the tax consequences of an unlawful dividend?
There is no single tax treatment which applies to every unlawful dividend.
Where a director-shareholder knew, or should reasonably have known, that the dividend was unlawful and has an obligation to repay it, HMRC may treat the amount as money owed back to the company rather than ordinary dividend income.
This can bring the director’s loan rules into play.
An innocent shareholder who was not required to repay the money can be treated differently.
An unlawful dividend also does not automatically become salary.
Trying to change a dividend into salary after the event could create separate PAYE, National Insurance and payroll-reporting problems.
If the dividend has already been included on your Self Assessment return or in completed company accounts, ask your accountant whether anything needs to be amended.
What if the company is insolvent?
Unlawful dividends become much more serious if the company cannot pay its debts.
If the company enters liquidation, the liquidator will look closely at payments made to directors and shareholders before the company became insolvent.
This can include dividends which were paid without sufficient distributable profits.
The liquidator may seek to recover the money from the director or shareholder.
Directors also have additional responsibilities when a company becomes insolvent or is approaching insolvency. Continuing to take money from the business while tax bills, suppliers and other creditors go unpaid can expose directors to personal claims and, in serious cases, possible disqualification.
If your company is struggling to pay its debts, take professional advice before paying any further dividends.
How can you avoid paying unlawful dividends?
Most problems can be avoided by keeping a close eye on the company’s accounts throughout the year.
In particular:
- keep your bookkeeping up to date;
- check accumulated profits and losses rather than relying on the bank balance;
- allow for Corporation Tax and other liabilities before deciding how much is available;
- prepare interim or management accounts if the annual accounts are out of date;
- record dividend decisions properly and issue dividend vouchers;
- review regular dividends if company income falls or costs increase; and
- ask your accountant to confirm the available figure if you are unsure.
Accounting software can give you a useful running view of profit, but it is only as accurate as the information entered into it.
It may also show an accounting profit figure without making every adjustment needed to work out the amount legally available for dividends.
Never use the company bank balance on its own to decide how much you can take as a dividend.
What should you do if you’ve paid too much?
If you discover that your company has paid an unlawful dividend, don’t try to rewrite what happened.
Stop taking further dividends, keep the original records and ask your accountant to work out exactly how much was unsupported.
Depending on the circumstances, you may need to repay the money or have the amount recorded through your director’s loan account.
Finding the problem early is much easier to deal with than allowing the balance to build up over several months or carrying it into completed accounts and tax returns.