What are illegal dividends?
Illegal dividends are dividends paid when a company doesn't have sufficient distributable profits. Directors may be personally liable to repay them, and they can be treated as director's loans with tax consequences.
Detailed Explanation
Understanding illegal dividends
An illegal dividend (sometimes called an ultra vires dividend) is any dividend that exceeds a company's distributable profits at the time of declaration.
What are distributable profits?
Distributable profits = Accumulated realised profits - Accumulated realised losses
This includes: - Current year profits (after Corporation Tax) - Retained profits from previous years - Minus any accumulated losses - Minus previous dividend payments
How illegal dividends happen
Common scenarios: 1. Director takes dividends without checking profits - relies on bank balance instead of accounts 2. Interim dividends exceed final profits - business performs worse than expected 3. Losses in prior years not accounted for - accumulated losses wipe out current profits 4. Multiple shareholders - total dividends exceed what's available 5. Corporation Tax not accounted for - profits are overstated before tax
Consequences for directors
1. Personal liability to repay - Directors who authorised the dividend are jointly and severally liable - The company (or its liquidator) can demand repayment - This applies even if the director acted in good faith
2. Treatment as director's loan - HMRC may treat the illegal dividend as a director's loan - If not repaid within 9 months of year-end: - Company pays 33.75% Section 455 tax on the outstanding amount - Director may owe Benefit in Kind tax if the loan exceeds £10,000
3. Income Tax implications - The dividend may still be taxed as income in the director's hands - Or reclassified as salary (with NI implications) - HMRC decides on a case-by-case basis
4. Insolvency risks - If the company later becomes insolvent, a liquidator will pursue repayment - Directors could face charges of wrongful trading or misfeasance - Personal guarantees may be called upon
How to avoid illegal dividends
- **Prepare management accounts** before each dividend declaration
- **Track distributable profits** throughout the year
- **Account for Corporation Tax** when calculating available profits
- **Keep proper board minutes** documenting the profit position
- **Use accounting software** that tracks retained earnings
- **Seek advice** if your company has accumulated losses
What to do if you've taken an illegal dividend
- **Repay the amount** as soon as possible
- **Reclassify in accounts** - treat as director's loan until repaid
- **File corrected tax returns** if needed
- **Get professional advice** - an accountant can help minimise the tax impact
- **Document the remedial action** - shows good faith to HMRC
Can shareholders be liable too?
Shareholders who knew or ought to have known the dividend was illegal may also be required to repay it. For director-shareholders (the most common scenario in small companies), this means double liability.
Prevention is the best approach
Always verify distributable profits exist before declaring any dividend. Use up-to-date management accounts, not just your bank balance.
Source: Companies Act 2006 Section 830-831
Real-World Examples
Ignoring Preliminary Accounts
A small design agency declares a significant dividend based on optimistic preliminary accounts, but the year-end audit reveals lower profits due to unexpected expenses. The dividend, based on inaccurate early figures, is now potentially illegal, and the directors face repayment obligations.
Dividend Exceeding Retained Profits
A software company has £10,000 in retained profits from previous years. They have a very profitable year and declare a £30,000 dividend. However, they forget about a previous year loss of £25,000 and now the dividend is illegal by £15,000 (£10,000+£30,000-£25,000 = £15,000 distributable profit).
Misunderstanding Realised vs. Unrealised Profits
A property development company values its assets upwards based on market conditions, creating a paper profit. They declare a dividend based on this unrealised gain. However, only realised profits (from actual sales) can be used to pay dividends, making this distribution illegal.
Common Mistakes to Avoid
- Failing to accurately calculate distributable profits before declaring a dividend is a common error.
- Ignoring accumulated losses from previous years when calculating distributable profits can lead to an illegal dividend payment.
- Treating unrealised profits (e.g., from asset revaluations) as distributable profits is a frequent misunderstanding.
- Not keeping detailed records of retained earnings and previous dividend payments makes it difficult to determine distributable profits accurately.
Frequently Asked Questions
What happens if I accidentally declare an illegal dividend?
HMRC will likely treat the illegal dividend as a director's loan, triggering income tax and National Insurance contributions on the amount. The company must also repay the illegal portion of the dividend to the company.
Can I use future profits to cover an illegal dividend?
No, you can't retroactively 'legalize' an illegal dividend. The dividend was illegal at the point of declaration. Any future profit will only impact the director's loan position if the dividend is not repaid.
What if I'm a director and the company can't afford to repay the illegal dividend?
As a director, you have a legal responsibility to repay the illegal dividend. If the company becomes insolvent and cannot recover the overpayment, you may be personally liable to repay it to creditors. Legal advice is strongly recommended.
Does insurance cover illegal dividends?
Directors and Officers (D&O) insurance *might* cover the costs of defending a claim related to an illegal dividend, but it won't cover the illegal dividend itself. Review your policy carefully for coverage specifics.
Practical Tips
- Maintain a detailed spreadsheet tracking your company's profits, losses, and dividend payments to easily calculate distributable profits.
- Consult with your accountant before declaring any dividend, especially if your company's financial situation is complex or changing rapidly.
- Consider using accounting software that automatically calculates distributable profits to reduce the risk of errors.
- Keep minutes of all board meetings where dividends are discussed and declared, clearly stating the amount of distributable profits available at the time.
Related Questions
How much dividend can I take from my company?
You can take dividends up to your company's available profits (retained earnings). There's no legal maximum, but you'll pay dividend tax above the £500 dividend allowance.
When should I declare dividends?
Declare dividends when your company has sufficient distributable profits, typically quarterly or at year-end. Timing across tax years can reduce your tax bill by spreading income across basic rate bands.
What is a Director's Loan Account?
A Director's Loan Account (DLA) tracks money you personally owe to or are owed by your company. It's overdrawn when you owe the company money (borrowed more than you've put in).
Get instant answers to all your accounting questions
AccountsOS uses AI to answer your tax and accounting questions in plain English. No more Googling or waiting for your accountant.
Get Started FreeFree during Early Access - No credit card required