Illegal dividends and insolvency explained

Illegal dividends and insolvency explained

May 11, 2022 by Sandra

Dividends are a tax-efficient way of securing remuneration from a limited company.

Profits made by a limited company are distributed to shareholders through the declaration of dividends; and quite often, with SME businesses, the directors and shareholders are one and the same.

In these situations, directors might take a minimum salary and pay the rest of the remuneration via dividends. However, before a dividend can be paid, two criteria must be met:

  1. The company must have the necessary profits available in order to pay the dividend, and
  2. Any payment must be made with reference to the company’s relevant accounts. These may be annual accounts or specifically prepared interim accounts, but they must show all assets and liabilities and include provision for any future liabilities, such as corporation tax.

But what happens if a dividend is paid illegally? What are the consequences for directors? And what happens should a company become insolvent?

We explain everything you need to know about illegal dividends and insolvency below…

Your questions about illegal dividends and insolvency answered.

What are illegal dividends?

According to the Companies Act 2006, “a dividend of distribution to shareholders may only be made out of profits available for the purpose.”

To put it simply, then, dividends become unlawful when insufficient profits exist within a company to cover the amounts paid.

Additionally, a dividend may be illegal if:

  • authorisation has not been provided in the correct format
  • a dividend voucher (a sort of receipt for tax purposes) has not been completed

Dividends deemed illegal by HMRC may be classified as salary, which means that tax and National Insurance must be paid.

In what situation might dividends be paid illegally?

Sometimes it is simply a case of miscalculation of profits, or failure to complete board meeting minutes that sanction the release of the dividends. Or, it could be that a dividend voucher hasn’t been completed, as explained above.

However, other circumstances that could result in illegal dividends also include poor record-keeping, or even back-dating authorisation for previously issued dividends. This is considered a fraudulent activity by HMRC and you would be fined accordingly.

Declaring a lack of knowledge of the rules surrounding dividend payments unfortunately just isn’t a good enough excuse.

Basically, not being aware won’t get you off the hook and won’t prevent you from being held personally liable for business debt as a company director.

So, will I be held personally liable?

In a nutshell, yes.

Section 847 of the Companies Act 2006 states that if s shareholder knows, or has reasonable grounds to know, that a dividend they have received has been made in breach of the criteria, they are liable to repay it.

If the shareholder is also a director of the company, they will struggle to demonstrate that theft didn’t have the necessary knowledge.

Likewise, if a director authorises a dividend to be paid when there are insufficient profits available, they will have acted in breach of their duties and may even be guilty of misfeasance under Section 212 of the Insolvency Act 1986.

As such, you will need to repay the funds, and you may even find yourself facing director disqualification.

How can I ensure that dividends are legally paid?

In order to establish whether dividends can be paid or how much you can afford to pay; you need to prove that the company has sufficient funds and profits to do so

The latest year-end accounts might not be enough; the legality of your dividends rests on the accuracy of your calculation. So, if necessary, you might need to provide real-time information or prepare interim accounts

The best way to do this is to ask your account to prepare the accounts for you, as they will be able to shoes whether or not there is sufficient profit available after all liabilities have been deducted.

What happens if my company becomes insolvent?

If your company becomes insolvent, it is your responsibility as a director to act in the best interest of your creditors - and paying your shareholders dividends means you are definitely not acting in your creditors’ interests!

It may be that a dividend was paid unlawfully, and you weren’t aware that your company was struggling, but unfortunately, the responsibility still relies on you as a company director as one of your responsibilities is to be aware of your company’s financial position at all times.

The fact is that continuing to trade whilst insolvent, however well-meaning your actions, is a serious offence.

A healthy cash flow and profits can sometimes lead to a mistaken sense of security - but things can change quickly, which is what you should be in constant communication with your accountant to ensure that you have sufficient funds after all liabilities have been accounted for.

How McAlister & Co can help

If you are a company director who is concerned about unlawful dividends or insolvency, it’s important to seek expert help and advice as soon as possible.

When insolvency and illegal dividends are combined, you will need to justify your actions on both counts, so you should always contact a licensed insolvency practitioner to decide on your next steps.

Here at McAlister & Co, we are one of the UK’s leading insolvency experts, and there’s nothing we don’t know about business rescue and recovery.

So, if you are a company director or even an accountant who is concerned about illegal dividends, contact us for FREE confidential advice.

New call-to-action

Filed Under: Business Insolvency

We don’t need personal or company details to answer initial questions on your situation:

Call 03300 563 600

Recent Posts