Dividends can only be drawn when a company has sufficient reserves/retained profits.
Often shareholders don’t take the right steps to taking their dividends legally.
One of the tax advantages of running a small limited company is that usually the directors also the shareholders and they can opt to take a higher level of dividends forfeiting salary.
It is well known that salary taken from a company is taxable under PAYE and includes a large slice of National Insurance. However ‘salary’ drawn as dividend avoids Employee’s National Insurance of 12% and Employer’s National Insurance of 13.8% as well so a very large saving.
It does seem too good to be true and for a profitable company it is a very good way of saving tax.
In addition if the director/shareholder is not a higher rate tax payer hitting the 40/45% tax rate then there is no extra income tax payable on dividends. So, you can see why so many smaller limited companies use this legal way to save tax.
So what’s all the fuss?
If a company is solvent and the dividends are drawn properly there is not an issue. However dividends can only be paid once a company has been going at least six months and only out of profits.
A company cannot pay a dividend if it has accumulated losses and it must also comply with the legislation on correctly voting and paying dividends.
If it all starts to go wrong and a company becomes insolvent and enters liquidation or administration one of the matters that the appointed insolvency practitioner (“IP”) has to do is investigate what happened and look for unusual transactions.
Quite often, creditors owed money by the company will be aware of matters that the IP should look at and draw these to their attention.
It may not seem fair but quite often we do have to ask the shareholders to pay back the dividends that they have taken so that we can repay this money to the creditors.
All dividends taken whilst the company was losing money and had accumulated losses are ‘illegal dividends’ and as such have to be repaid.
It is quite a shock for some shareholders to find this out and is the last thing that they want to hear when they are already having to deal with a failing company.
We have found that what often happens in practice (and when issues tend to arise) is that shareholders draw lump sums sporadically as and when the cash flow allows it and then retrospectively decide how it should be treated (usually when the company’s annual accounts are due to be produced, which could be as much as up to 19 months later).
Little or no paperwork has been produced and no steps were taken to ensure solvency at the time that the money was paid.
What should happen when drawing a dividend?
The directors should draw up regular accounts to be used to show that the company was solvent when dividends were voted. If in doubt they should check with their accountant.
Dividends should be voted by the directors and minutes kept that they have approved them. This should happen before the money is drawn out and not after.
If the solvency of the company is in doubt then any money drawn by the directors should be paid as salary through PAYE (of course another cost just when they do not need it).
In addition it is wise to make sure that the salary taken is a fair amount for the work done and not above a ‘market value’ as that can cause problems as well.
If you are in doubt always seek professional advice.