What are Unlawful Dividends, and How Do You Avoid Them?

Dividends are illegal when the company's profits are insufficient to cover the sums handed out. “A dividend or distribution to shareholders may only be made out of profits available for the purpose,” according to the Companies Act of 2006, which specifies that “a dividend or distribution to shareholders may only be made out of earnings available for the purpose.”

A dividend may also be considered illegal if:

• The correct format for approval has not been provided: prior to authorisation, minutes from a board meeting conducted to authorise the payment of a dividend should confirm directors' consideration of profit levels available. Even if you're a lone director, you'll need these minutes to meet HMRC standards.
• This is a ‘receipt' for tax reasons, and a dividend voucher has not been filled. It should include the dividend rate per share, the dividend amount, and the tax credit amount.

The word "ultra vires," which means "beyond the powers," is occasionally used to describe an illegal payout. To put it another way, directors do not have the authority to authorise such a payment from business funds.

HMRC may classify unlawful dividends as salary, triggering the payment of National Insurance and tax. As a result, if you want to get a regular dividend, you'll need to be sure that the company's profits can support the payment on a regular basis.

In what circumstances might dividends be paid in an unauthorised manner?

• Illegal dividends can be issued as a result of miscalculation of earnings or the use of an inaccurate figure, as well as failing to complete board meeting minutes and the dividend voucher indicated above.
• Poor record-keeping, both in terms of administrative and financial papers required prior to permission, could easily lead to their problem.
• Backdating permission for previously issued dividends would be considered fraudulent by HMRC. Penalties and/or fines would be imposed if this was discovered.

As a corporate director, claiming ignorance or unawareness of the rules governing dividend distributions does not exempt you from being held personally accountable for business debt.

Authorization must be based on current and accurate earnings numbers.

When determining current distributable profit levels, the most recent year-end reports may not be suitable. Before a dividend is paid, you must demonstrate that the company has adequate profit, either through the use of real-time data in online management accounts or the preparation of interim accounts.

The precision of these calculations is crucial to the legality of dividends, so you may want to have your accountant draught the accounts or double-check their accuracy. After all of the relevant liabilities have been eliminated, they should have enough profit available to meet the payment. “Cumulative realised profits less... accumulated realised losses,” in other words

What happens if your business goes bankrupt?

Directors are exposed to significant liabilities if the firm goes bankrupt due to their failure to behave properly. If a dividend was given illegally, it may not have been evident to individuals who made or received the payment, but it does not change the fact that the directors are responsible.

A strong cash flow and current profitability can lead to a false sense of security. Directors who believe their firm is solvent may discover, after additional inquiry, that a future liability, such as Corporation Tax, paints a different picture and puts the company insolvent.

What are the ramifications for board members of companies?

HMRC will claim that you were aware, or should have been aware, that a dividend was illegal. It is a director's job to be informed of your company's financial situation at all times, and the directors are solely responsible for this.

Insolvency makes this obligation an inextricable component of the situation. Continuing to trade while bankrupt is a significant violation that fails to put creditor interests first, no matter how well-intentioned your actions as a director may be.

When insolvency is coupled with the distribution of illegal dividends, directors will be under tremendous pressure to justify their actions on both counts. If you are concerned about imminent insolvency or the problem of illegal dividends, you must seek assistance from a skilled Insolvency Practitioner.

An illegitimate capital return to shareholders

If the company goes bankrupt and a shareholder who received an illegal dividend is not legally obligated to reimburse it, the Official Receiver or practitioner liquidating the firm's assets will seek restitution from the director(s).

If you find yourself in a position of insolvency, your chances of facing legal action skyrocket. So, after an illegal dividend has been identified, is there anything that can be done to limit the risk?

• An explanation that a shareholder received an illegal payout and that actions are being taken to retrieve the money might be added to the dividend letter.
• It's also worth noting that the board of directors has agreed that no additional dividend payments will be made until the matter is handled.

Dividends paid illegally have substantial consequences for directors, and not just in the case of insolvency. If HMRC considers a payout should be classified as salary, they are likely to pursue the necessary NIC and tax payments with vigour. Your sole defence may be to follow a prescribed administrative procedure prior to authorisation and issue.

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