The dividend ‘dilemma’: How to protect yourself and your business
January 23, 2022
It is common practice for director/shareholders of owner-managed businesses to take remuneration by way of a low basic salary paid through PAYE, with the remainder being taken as shareholder dividends. This is because dividends typically attract a lower rate of tax (both for the individual and the company) than would be payable as an employee. Yet, although this is common practice and legal for Directors to do, there is a dilemma potentially present in regard to these dividend payments.
What is the dividend dilemma?
Most people operate in a monthly financial cycle in line with their mortgage, utilities, and other household payments. Therefore, a director/shareholder will normally draw a fixed monthly sum, perhaps with no regard to what part is deemed to be the salary or the dividend. However, the payment of dividends to shareholders is precise with the rule being that they should only be taken from a company’s distributable profits. Dividend payments also require clear documentation that needs to be drawn up within 30 days of payment. In the absence of such documentation, it is open to HMRC to suggest that all payments made to the Director are subject to PAYE.
Whilst it is common practice for dividends to be declared on an annual basis so as to account for the payments made to the director retrospectively as salary or dividend, the crux of the matter is that this scenario can only work legally if the company’s trading is profitable.
What if the company is making a loss?
If a company has been making a loss, it may find that it does not have enough profits to declare a dividend, sufficient to repay the amounts drawn throughout the period. As such, before declaring a dividend, you need to be sure that the company can afford this once you have accounted for all outgoings, including the corporation tax which will be due on profits.
As a general principle, unless a dividend is correctly declared (see below) before, or at the time a payment is made, any monies drawn in excess of their salary will remain repayable as a loan owed to the company by the director/shareholder personally, which is and repayable on demand. The correct method of declaration of dividends by the Director(s) must be backed by some calculation showing that distributable profits are available, followed by the annual vote by shareholders, which formalizes the dividends declared by the Directors in the year.
How might a Director unlawfully claim a dividend?
In many instances, declaring an unlawful interim dividend is an honest mistake, whereby upon reconciling the company’s profit at the end of the accounting period, directors find that actual profit is not at the level which was anticipated at the time when the dividends were announced. This could be due to a multitude of reasons such as a lengthy period of illness, a significant drop in sales (e.g. Covid related), or unexpected operational challenges that negatively impacted on financial performance. In other instances, directors may have simply financially miscalculated and declared dividends based on the company’s bank balance rather than after-tax profits.
Therefore, if trading is profitable a dividend can be declared in order to cancel the loan out. The problem arises if trading has not been profitable or (worse) if an insolvency event occurs before the annual cycle of drawing and dividend/repayment is complete.
If I have declared too much dividend, what are my options?
If the mistake comes to light some months after the dividend was declared, it is likely the funds have now been spent. The easiest course of action at this stage is to use future sales to generate adequate enough funds to bring the company back to a profitable position. However, it is always worth seeking advice from your accountant if you are in this position.
In circumstances where the shareholder also holds the position of company director, then an overdrawn directors’ loan account will be created and benefit in kind charges will apply to loans in excess of £10,000. Should the loan remain outstanding beyond 9 months following the company’s year-end date, a 32.5% charge will be levied on the outstanding balance; it will also be subject to corporation tax. This charge is known as a section 455 tax and this can be reclaimed once the loan has been cleared in its entirety.
What happens if the company falls into insolvency?
An insolvency practitioner (IP) once in office, has an obligation to ingather and realise the assets of the company, which includes debtor collection. It follows that if the appointment takes place when there have been amounts drawn in excess of salary, without dividends having been declared, the IP will have a duty to conduct investigations and attempt recovery of the amounts due to the company from the directors/shareholders personally. No shareholder dividends can be declared once a company is in an insolvency process, and therefore the predicament can be serious (and life changing) for those Directors who find themselves in this position. A dividend declared (or other payment made) at a time when the company is insolvent may also be challenged by an IP, as a transaction at under value. Directors are advised to seek legal advice if they believe the circumstances, as set out above, may apply to them.
Will the IP allow me time to pay?
An IP will listen to sensible commercial offers for repayment, and it may be possible for this to be paid over a realistic and acceptable period with instalments, or from lump sum payments e.g. from the sale of personal assets, if the director/shareholder is not in a position to repay immediately. However, in circumstances where the director/shareholder has insufficient assets to ensure repayment of the outstanding loan, it may be that personal insolvency and bankruptcy are the only options left for a Director.
Can I protect myself against this potential liability?
With carefully documented accounting records, you should be able to spot the point by which concerns will become obvious and when to speak with your accountant and take advice. If you think profitability is under threat, your accountant may advise you to resort to PAYE as the basis for your remuneration rather than the dividend model. While this would make your company liable for more tax, it will preclude you from being personally liable should an insolvency event be on the near horizon.
At this point, all decisions, especially those relating to the payment of dividends, should be carefully documented, and referenced accordingly. There is the real likelihood that the IP will want to see these records and ensure matters have been dealt with correctly.
If the potential insolvency event is being driven by your creditors, then negotiating a deferral of payment, or time to pay arrangement, for as long as reasonably possible is recommended, which would allow you time to make good. If the insolvency event can be delayed, then so will the time by which you would be liable for the overdrawn director’s loan.
Get in touch
If you believe you could be impacted by these issues and you would like to arrange an initial meeting to discuss the best way forward, contact us at your nearest local office to arrange a no obligation and confidential call with one of our Partners. The earlier you take action, the more options are available to you.