Illegal Dividends: Avoid 33.75% Tax and Big Penalties

:: 00:00

Welcome to another episode of I Hate Numbers, and in today's episode, I'm going to be tackling a topic that affects thousands and thousands of company directors and shareholders, and that's illegal dividends and their tax consequences. Now it sounds heavy, don't worry. I'm going to break it down using examples, some more explanations and action steps.

:: 00:20

And by the end of this episode, you'll understand what an illegal dividend actually is, why they create problems, and they can be quite serious, the tax consequences of that, both for the company and the director, how HMRC goes about identifying them and more importantly, what can you do to avoid getting yourself into hot water and to trouble.

:: 00:39

Now, getting this wrong can cost you money, stress, and even personal liability. So firstly, what is an illegal dividend? So let's start with the basics. A dividend is money a company pays out of profits to its shareholders. It's what's called an appropriation. Now, here's the catch - profits mean distributor profits, not just what's in your bank balance.

:: 01:01

Now, the law, the Company's Act 2006 says dividends can only be paid from accumulated realised profits after losses are deducted. It sounds a bit of a mouthful, doesn't it? What does it actually mean in practical terms? Well, let's throw in an example to illustrate this. Now, imagine your company bank account shows 20,000 pounds in cash.

:: 01:21

It looks pretty healthy, doesn't it? But behind the scenes, your company has got losses that it's built up of 25,000. Now, even though the cash is there in the bank, the accounts, the profitability or lack of it is showing 25,000 pounds of accumulated losses. Technically speaking, you don't have distributor profits.

:: 01:38

So if you pay a dividend in that situation, it's illegal. Now, you're not necessarily going to go to prison, by the way, but it's actually contrary to the Company's Act. Now you can actually pay dividends in a year that you're making a loss, but that's only if your total reserves have built up such that they're positive.

:: 01:55

So if historically you've made profits and you've just had a bad year, but in total terms you've got cumulative total profits there, then fine, no problem. However, if your built up losses outweigh that, then dividends are off the table. Now there is a question of why does illegal dividends cause problems?

:: 02:13

That's more than just a technicality. They are in breach of Company Law. There is a risk. They can make your company insolvent and they can trigger big tax problems both for you and for the company. Think of it like driving without insurance. You might not get caught straight away. You could probably get away with it in the short term, but if you have an accident, if trouble hits, the consequences can be catastrophic.

:: 02:32

Obviously, in illegal dividends, nobody's going to sort of lose their life or get injured, but you understand the analogy, hopefully. So what are the tax consequences for the company? Now if you do declare a dividend without enough profit, the law will treat it as void. That means in reality, it never actually happened.

:: 02:49

If shareholders knew it was illegal, they have to pay it back, but if they don't, the problems manifest and grow. And here's where tax law kicks in. Now we have something called loans to participator rules. Don't you just love the language? Now, when directors or shareholders keep illegal dividends, HMRC sees them as mere loans and with loans comes conditions.

:: 03:09

If those loans aren't repaid within nine months and a day after the company's yearend is finished, the company has a tax charge - and that charge, wait for it, is an eye-watering 33.75% of the gross payment. Well, that's the same rate as the higher dividend tax rate for individuals. Now, it doesn't matter, by the way, if you are individually a personal tax payer, that 33.75% tax charge

:: 03:34

stands. And that applies even if your company is making a loss. Now, the good news is if the loan is eventually repaid back or written off, HMRC will refund that tax back to the company. But you've got a long wait and it's quite protracted and waiting years for a refund isn't really a smart way to run a business, but it's still there and it's a one-off charge.

:: 03:56

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:: 04:21

And what about the tax consequences for the directors and the shareholders? So let's take a dive into the personal side. Now, directors and shareholders face additional roles. We're going to first look at the small loans exception. Now if the loan is considered what's called de minimis, a small value, 15,000, some relief may apply, but only if the shareholder is also a full-time director and they hold less than 5% of the share capital.

:: 04:45

If none of those conditions apply, then the relief doesn't apply either. Now, if you happen to be a director, owner of your own company, then obviously you're going to have more than 5% of the share capital. Now loans above 10,000 fall under a different set of rules called the employment related loan rules,

:: 05:01

effectively a Benefit in Kind. HMRC will take the view that if you receive more than 10,000 pounds out of the company, you are taking a beneficial loan and you're going to be charged interest on that. And currently interest rates are currently over eight percentage points on that. If you don't pay interest back to the company and you have that withdrawal free of any charges back to the company, then you've got a Benefit in Kind charge as well.

:: 05:25

It's going to be reported on a P11D, and they'll also be 15% Class One National Insurance payable by the company. Now if the load is subsequently written off, it counts as repaid, but HMRC will see that as additional income and there's potentially more tax. Now, let's imagine a situation here where the directors get themselves into a bit of a pickle.

:: 05:44

Now, Claire, a director, takes out an illegal dividend of 12,000. She doesn't repay that back within nine months, and HMRC will hit the company with a 33.75% tax charge. On top of that, Claire's got a benefit in kind charge because the loan is over 10 grand, potentially double trouble. Let's consider the area of liquidation and director risks.

:: 06:05

Now, the stakes get higher if a company subsequently goes into liquidation. Now, liquidators will review the director conduct for the past three years. They typically look for what's called illegal distributions, and if they can find them, the directors will be personally liable and forced to repay the dividend.

:: 06:21

Remember, that illegal dividend as such is taking company assets and the liquidator has a responsibility for recouping any value from assets. So if you have got an illegal dividend, the liquidator will be looking for you to pay that back. Now, there's a six year time limit, by the way, for recovering illegal dividends.

:: 06:38

It's rare, but it does exist and it is serious. What that means for a director. That could be personal financial loss. So it's not just the company's problem anymore, and legal liability does not protect you. Let's introduce our friends, HMRC. How do they identify illegal dividends? Well, it's a bit simpler than you think.

:: 06:56

HMRC tax returns are filed using what's called IXBRL taxed accounts. What that means is that technology makes it easier for HMRC systems, which are waking up and getting more active to spot inconsistencies. So if there's a correlation between negative reserves, but dividends being declared, HMRC will ask questions.

:: 07:15

They don't really need detailed forensics here. A simple correlation between reserves and dividends will be asking questions. So what are the practical steps that one can take to avoid these illegal dividends? Try not to put yourself into that risky situation, and here's a suggested checklist. Check and retain profits before you declare dividends.

:: 07:32

Remember, cash in the bank is not the same as profitability. Keep anchor and up-to-date management accounts. Use digital accounting systems like Xero. Talk to your accountant. Take advice from them if you're unsure, and if you do pay an unlawful dividend, pay it back quickly if you can to reduce the risk.

:: 07:47

Those monitoring your management accounts will show where you stand. Now, just some general FAQs on illegal dividends. Here's a short burst of questions I often get asked and with a short burst answer. Firstly, what's an illegal dividend in the Uk? Well, it's a dividend paid without sufficient retained profits to back it up.

:: 08:08

It breaches Company Law. Question number two, FAQ. What happens if you don't repay that back (that unlawful dividend)? Well, HMRC might apply the director loan rules, that means a potential 33.75% tax charge on the amount. FAQ Number three, how much is the tax charge without profits? Well, that could be 33.75% of the gross payment if that loan is not repaid or written off after nine months.

:: 08:33

FAQ number four, can directors be held personally liable? Absolutely, especially when it comes to a liquidation, directors can be forced to repay, and I've seen that happen many a time. So in essence, what should be the takeaways here? Well, review your dividend policy, make sure you've got the right accounting software in place.

:: 08:50

Get those regular accountant across you, check your retain profits, keep compliant and stress free. If you need some further help, you want to book a tax diagnostic review, clear answers, no jargon, practical steps, then check us out at www.ihatenumbers.co.uk and book your call now. Until next time, folks, plan it, do it and profit.