It is common that companies, particularly ‘one man band’ companies, exceed the allowable amount of dividends that are paid to the company shareholders.

The amount of a dividend is restricted to the reserves available in the company.  Reserves are the current profit or loss, after considering Corporation Tax, plus the profit reserves from the previous years. Another consideration is the available cash if the dividend is to be paid when it is declared.

If a dividend is paid where there are insufficient reserves, it is deemed an illegal dividend.

It is important to be able to read and understand the company’s current profit and loss account and balance sheet to ensure that sufficient reserves are available before paying a dividend.

If an illegal dividend is paid, the creditors of the company can request that the shareholders repay the dividend to the company. This is because the cash used to pay the dividend should be used for the trading of the company and paying the creditors instead of paying a dividend that shouldn’t exist.

Having illegal dividends in the company accounts can also make the company look insolvent having negative balances on the balance sheet. This can affect the company’s ability to gain credit from a lender or suppliers and may breach current agreements with lenders or supplier.

There are tax consequences to consider if illegal dividends are paid:

• It may provide HMRC with source to start enquiry.

• It is also possible that HMRC may state that the dividends should be reclassified as loans instead of dividends due to the insufficient reserves.  This could potential lead to the company having overdrawn directors’ loan accounts if the directors are the shareholders.

• If dividends are reclassified as loans, there are more considerations:

The shareholders will need to approval the loans if the loans are more than £10,000, even if the directors are the shareholders.

P11D forms will need to be completed to account for the ‘beneficial interest’ on loans of more than £5,000. This is because it is unlikely that interest will be paid to the company on the ‘beneficial loans’ - a loan received by way of your position with the company.  The current HMRC interest rate for beneficial loans is 4%. 

As with all P11D benefits, class 1A National Insurance will need to be paid by the company on the benefit.

The company will also have to pay HMRC tax of 25% on the overdrawn directors’ loan balances that still exist 9 months after the accounting period in which the loan was paid. This tax relates to s455 of CTA 2010 formerly s419 of ICTA 1988.  Once the loans are repaid, the tax will be repaid to company 9 months after the accounting end date in which the repayment is made.  Partial repayments attract a pro rata refund.

It is possible to write off directors’ overdrawn loans in the accounts but adequate reserves are required to do this.  The write off is treated effectively as dividend income, if the correct procedures are carefully followed.  There is also a chance that Corporation Tax relief will be given on the write off but again the correct procedures must be followed and the correct paperwork must be completed.  This however, is a contentious issue with HMRC. Please contact us before considering this option.

Please contact us if you would like to discuss this further.