This is fine when things are going well, but some owners fall into difficult territory when their company enters a formal insolvency, as dividends have been paid at a time when the company has not earned sufficient profits. These dividends can be classified as illegal and reclaimed when the company is insolvent.
But it is my wages?
Many business owners receive shareholder dividends instead of or on top of a nominal salary as a tax efficient method of being paid for their efforts.
Typically they draw their “wages” out of the business in two tranches. The first, a weekly or monthly wage, which is paid through the PAYE system, which is at a level to qualify for National Insurance benefits and the second payment, which normally represents the majority of their “wages” is paid as a weekly or monthly sum which is treated as dividends, when the end of year accounts are prepared. However, a problem arises when the company has not actually made a profit in the year and does not have sufficient distributable reserves of profit from which to declare dividends to the owner and these become unlawful dividends.
What is an unlawful dividend?
The technical definition in The Companies Act 2006 states that 'a company may only make a distribution out of profits available for the purpose'. In this context profits available for the purpose are the accumulated realised profits less accumulated losses, not including any future profits, not yet earned.
Therefore a company must make sure it has sufficient retained profits to allow the dividend to be paid. Where dividends paid exceed the company’s retained profits, the dividend is unlawful and therefore the payments cannot be classified as a ‘dividend’.
So if it is not a dividend what can it be classified as?
The payments cannot retrospectively be classed as PAYE salary as with the introduction of Real Time Information in relation to payments to employees subject to PAYE deductions, directors are unable to treat the payments as wages subject to PAYE. As the payment cannot be classified as PAYE, the only other alternatives are for the directors to repay the amount, or treat the ‘unlawful’ balance drawn out as a loan to the director and repay the balance in future years when profits are earned and dividends can be lawfully paid.
So what is the problem?
The problem arises when the company enters a formal insolvency process, such as liquidation, as these unlawful dividends have to be treated as loans to the director, and if they remain unpaid, the liquidator must look to recover these loans for the benefit of creditors.
This can be a harsh outcome, as in trying to find a tax efficient method to receive salary, the director has in fact not received a salary but instead borrowed money to live on from the company. There is also a risk that HM Revenue & Customs may look to charge income tax and national insurance to the director personally on the value of the loan as a benefit in kind.
In conclusion, if the company is not making profits, there are real drawbacks to taking money out of a business as dividends and many business owners find out too late and simply continue drawing the same amount from the business in good and bad times, without thinking if the implications of doing so.
If you have concerns as to whether your dividends may be unlawful, please speak to us or contact your accountant.