Avoiding Unlawful Dividends as a Company Director
Understanding Unlawful Dividends
For most UK contractors operating via a limited company, paying dividends to shareholders is a routine method of extracting profits. However, if a company issues dividends exceeding its available distributable profits, those dividends are deemed unlawful (or illegal). This misstep exposes directors to financial and legal risks.
It is critical for company directors to understand what constitutes an unlawful dividend and how to avoid common errors.
Legal Basis for Dividends
Section 830 of the Companies Act 2006 states:
“A company may only make a distribution out of profits available for the purpose.”
Distributable profits are defined as accumulated realised profits less accumulated realised losses. Directors must ensure sufficient profits exist before any dividend declaration. Relying solely on the company’s bank balance instead of up-to-date management accounts is a frequent cause of illegal dividends.
Key point: The presence of cash in the bank does not guarantee the existence of distributable profits.
Typical Causes of Unlawful Dividends
Unlawful dividends most commonly occur when:
Directors declare dividends based on cash balances, not profit levels.
Corporation Tax and other liabilities are ignored before making calculations.
Accounting records are not up-to-date or properly reconciled.
Management accounts or accounting software are not checked before distributions.
Example Scenario
| Bank Balance | Dividend Paid | Corporation Tax | Other Creditors | Distributable Profits | Unlawful Amount |
|---|---|---|---|---|---|
| £20,000 | £10,000 | £8,000 | £4,000 | £8,000 | £2,000 |
In this case, £2,000 of the dividend is unlawful and must be repaid or treated as a director’s loan.
Director Responsibilities and Risks
Directors must check and document the existence of profits before declaring dividends.
Failure to exercise reasonable care may result in the director being personally liable to repay the unlawful dividend.
If the unlawful dividend cannot be repaid immediately, it is typically reclassified as a loan to the director. This loan must be repaid within nine months of the company’s year-end to avoid a Section 455 Corporation Tax charge (currently 32.5% of the loan amount).
Shareholders who knew, or should have known, a dividend was unlawful may also be required to repay it.
Unlawful dividends are not criminal, but they are a breach of statutory duty and can have significant tax and financial consequences.
Correcting an Unlawful Dividend
The most effective remedy is repayment of the unlawful amount to the company. If immediate repayment is not possible, the dividend is reclassified as a director’s loan.
HMRC Guidance (CTM20090):
“Frequently the dividend is found to have been paid unlawfully. If that is the case, the company’s advisors will be able to rectify the situation by reducing or extinguishing the amount of the dividends and drawing up approved accounts showing only such amount of dividends as can be supported by distributable profits. Corresponding adjustments will be made to directors’ loan accounts if the dividends have been credited to such accounts in the company’s books, or in draft accounts.”
For further details, review HMRC’s official manual CTM20090 and CTM15205.
Step-by-Step: Avoiding and Addressing Illegal Dividends
Before Declaring Dividends:
Prepare up-to-date management accounts.
Ensure all transactions, invoices, and bank statements are reconciled.
Calculate retained (distributable) profits after accounting for all taxes and liabilities.
Document the directors’ decision and the evidence supporting available profits.
Seek advice from your accountant if uncertain.
If a Dividend is Found to Be Unlawful:
Repay the unlawful portion to the company as soon as possible.
If immediate repayment is not feasible, record it as a director’s loan and clear the balance within nine months to avoid additional tax.
Adjust management accounts and dividend paperwork to reflect the corrected position.
Common Pitfalls and How to Avoid Them
Mistaking cash for profit: Only profits after tax and liabilities count as distributable.
Failing to update records: Out-of-date accounts can hide liabilities.
Over-reliance on draft figures: Use only finalised, accurate management information.
Ignoring interim accounts when switching accounting frameworks (GAAP): This can distort profit calculations.
Misuse of dividend waivers: These can trigger anti-avoidance rules if not structured for genuine commercial reasons.
Dividend Waivers and Settlements Legislation
Dividend waivers permit some shareholders to forgo their dividend entitlement, enabling others to receive a larger share. While sometimes commercially justified, waivers between spouses or related parties may prompt HMRC scrutiny under the settlements legislation. For a detailed analysis, see HMRC’s settlements guidance.
Leveraging Accounting Software
Modern accounting software, such as FreeAgent, can display real-time profit and tax positions, reducing the risk of error. However, the accuracy of such tools depends on the quality and completeness of input data. Ensure all relevant information is entered and reconciled before relying on software reports.
Key References and Further Reading
Practical Checklist for Directors
Do not declare dividends based on bank balance alone.
Always prepare management accounts before a dividend declaration.
Confirm distributable profits after all liabilities and taxes.
Keep records of board meeting resolutions and supporting evidence.
Consult your accountant if in doubt.
Proactive management and professional advice are the best defences against unlawful dividend errors.
Next Steps
Review your dividend policy and procedures.
Schedule regular management account updates.
Speak to your accountant regarding best practices for dividend declarations.
If you have concerns about past dividends, seek immediate professional advice to mitigate risks.
It is far simpler to prevent an illegal dividend than to correct one after the fact.
