Illegal dividends? Don’t worry, you won’t go to prison for receiving illegal dividends, but you could end up with unexpected tax liabilities.

Here’s why and how to avoid it.

What are dividends?

If you trade through a limited company, then you probably receive a small basic salary and receive the rest of your income as dividends.

Dividends are the money paid to you by the company because you are a shareholder.

Dividends are not like a salary. They are paid out of a company’s post-tax profits.

Please note: If your business is a sole trade or partnership, then it can’t pay dividends.

Why are profits important?

Before you pay a dividend, you need to know if your company has sufficient profits.

Beware, having cash in the bank does not necessarily mean you have a profit that can be distributed. That money could be owed to suppliers or even to HM Revenue & Customs.

Hopefully, your accounting system will tell you how much profit you’ve made (if it doesn’t, or if you haven’t got one, then you need to get one that does in place – we can help).

You will need to make an allowance of 20% for the Corporation Tax payable on the profits you have (remember, dividends are paid out of post tax profits). The balance, less any dividends already paid that year, should be available for distribution to the shareholders.

What happens if you pay too much in dividends?

 In the illustrated example, the company has paid £3,000 in dividends, but has made an operating loss for the year of £1,961 and has retained losses of £7,611.

It didn’t have profits available to distribute. So it should not have paid any dividends.

In this case, the information should have been available to the company before it paid the dividend. Therefore it shouldn’t have declared one.

This would be an illegal dividend.

Illegal dividends are potentially repayable to the company. This is especially likely to be the case if you can’t show you thought there were sufficient profits available to pay a dividend, and followed the correct procedures to declare the dividend.

HM Revenue & Customs will try to classify illegal dividends as either salary or a loan to the shareholder.

If they reclassify it as a salary, then they will demand Income Tax and National Insurance payments on the amount each shareholder received.

If it’s reclassified as a loan, not only does the amount become repayable, but either interest will paid on it by the shareholder, or they will be liable to Income Tax on the benefit-in-kind, and the company will pay Class 1A National Insurance.

If the loan is outstanding more than 9 months after the year-end, then the company will pay 25% tax on the balance (although this is repayable when the loan is repaid).

This makes it important to get right.

How to make sure you pay the right amount in dividends

Whenever a company plans to pay a dividend, it must check its profits to make sure it has enough to cover the dividend, then have a meeting of the directors and produce board minutes and vouchers. The minutes must be produced even if the company has only one director.

Remember – the amount you can receive in dividends each year without generating a personal tax liability will depend on what other income sources you have.

How we can help

We help make sure you know how much is available to pay in dividends each year, as well as how much of that you could receive before you have to pay any Income Tax.

We can make sure you have accounting software that will give you the information you need when you need it.

If that software does not produce board minutes and dividend vouchers for your records, then we can provide templates you can use.