For limited company owners, dividends are often a great method to take out your hard-earned profit in a more tax efficient way.
Taking money out through dividends isn’t always straightforward. It’s easy to make a mistake and end up facing an unexpected tax problem.
The most common mistake is when limited company owners view their dividends as their monthly ‘pay’. This viewpoint then results in the ltd company owners drawing out a sum of money each month as a ‘dividend’, with no regard to company performance. That is one big no-no.
This can result in illegal dividends and must be avoided.
Why your dividend might be illegal
There can a few reasons why a dividend might be illegal, including:
- Misunderstanding who can legally vote the dividend,
- A lack of documentation
- Not understanding the need for true profits to be available
As numbers people, we’d like to talk about the profit issue here. For a dividend to be legal there are several things that need to happen. Just marking a bank payment as ‘dividend’ isn’t enough.
Is there sufficient profit to award a dividend?
There needs to be enough ‘profit’ to be able to pay any dividend. You need to be sure this profit exists. So, you need to review the most up to date set of accounts or reports you have before any dividend is considered.
If you are in the ‘cloud’ accounting world, you may have access to this via a product like Xero or QuickBooks. Log in and scroll down to the bottom of your accounts or Balance Sheet report, where you usually see something like this:
For many small businesses, the bottom figure ‘Total Capital and Reserves’ is often a good indicator of whether a dividend can be paid (and potentially how much). However, the figure can contain values that can’t have a dividend paid from them, such as share ‘capital’ (£2 in the above) or ‘share premium’ (not shown here).
In this example, the company looks in a reasonable position on paper to pay a dividend. However, there are some common pitfalls that mean in reality there could not actually be enough profits to pay money as a dividend.
Is your book-keeping accurate and up to date?
One major pitfall can be if your book-keeping isn’t accurate. Your book-keeping may not have taken into account a lot of adjustments such as:
- The drop in value of the things (physical assets) your company owns (‘Depreciation’)
- Timing adjustments
- Provisions for expenses or income not yet made.
Other issues can include:
- Dividends in the software are being shown in the ‘Profit and Loss’ report rather than in the Balance Sheet.
- You are using last year’s accounts, so the data is likely to be out of date.
Get into the Balance Sheet habit
Get into the habit of reviewing the Total Capital and Reserves section of the Balance Sheet. It might not be completely accurate or current, but at least you’ll gain some awareness of whether a payment is likely to be ok as a dividend.
The most common scenario we see where dividend payments has gone wrong is where this ‘capital and reserves’ figure is very small, and the owner has not taken into account the adjustments for future tax, timing or depreciation.
My dividends might be illegal, what do I do?
There isn’t a generic answer we can give here as it varies wildly, based on your individual situation.
What we can say though that in many cases, the payment can often be reflected as a loan to the director instead. In reality, this is the key consequence of getting this wrong. Under the Companies Act, the shareholders could be asked to repay that dividend (essentially the same treatment as a loan).
I’m worried about making legal dividends
Review your figures and ask your accountant for help in understanding how this all works for you and your company. If you don’t have an accountant, or feel you aren’t making the most of dividends and other limited company tax opportunities with your current accountant, we can help. Just get in touch.
FAQs
1. What are dividends in a limited company, and why are they important?
Dividends are payments made to shareholders out of a company’s profits. They are crucial for owners to extract profit in a tax-efficient manner.
2. What are illegal dividends, and why should they be avoided?
Illegal dividends are payments made without sufficient profits or in violation of legal requirements. They can lead to unexpected tax issues and legal consequences.
3. Why might a dividend be considered illegal?
Reasons for illegal dividends include misunderstanding who can vote on dividends, lack of documentation, and not ensuring true profits are available for distribution.
4. How can I determine if there are enough profits to award a dividend?
Before considering a dividend, review the most recent financial statements or reports to ensure there is enough profit available. Tools like Xero or QuickBooks can help in this process.
5. What common pitfalls should I be aware of when assessing dividend eligibility?
Pitfalls include inaccurate bookkeeping that doesn’t account for depreciation, timing adjustments, or provisions for future expenses. Dividends should be reflected in the Balance Sheet, not just the Profit and Loss report.
6. What should I do if I suspect my dividends might be illegal?
If you suspect illegal dividends, seek advice tailored to your specific situation. In many cases, such payments can be treated as loans to directors, with potential repayment obligations under the Companies Act.
7. How can I ensure I am making legal dividends for my company?
Regularly review your financial figures, particularly the Total Capital and Reserves section of the Balance Sheet, and consult with your accountant for guidance on dividend legality and other tax opportunities.
8. What should I do if I need help understanding dividend payments and related tax opportunities?
If you lack an accountant or feel unsure about maximizing dividend and tax advantages for your limited company, reach out for professional assistance to ensure compliance and efficient financial management.