Limited companies can distribute profits they generate via dividends to company shareholders. However, you must ensure that all dividend distributions are legitimate, otherwise you could fall foul of HMRC.
Dividend declarations – the legal basics
In order to declare a dividend legitimately, you must firstly ensure that the money exists in the company’s books to accommodate the amount being distributed, and secondly you must make sure you record details of the declaration correctly.
The legal basis for dividends are contained in The Companies Act 2006. Section 830 states that ‘a company may only make a distribution out of profits available for the purpose’.
How do you calculate retained profit?
Dividends can only be paid out of retained profits. Retained profits are the funds remaining after all liabilities and expenses have been taken into account. If you have undistributed profits remaining on the balance sheet from previous financial years, this sum can be added to the current level of retained profit.
Turnover – expenses (costs) = Net Profit
Net Profit – taxes (Corporation Tax) = Retained Profit
If you have online accounting, which is becoming more and more widespread with the explosion in cloud computing software, then you may well be able to see a snapshot of your company’s finances at any given time – including the amount available to distribute as dividends.
If you do not have access to your realtime accounts, and you cannot accurately calculate your current position, you should ask your accountant to do so before paying a dividend.
What paperwork do you have to complete?
The board of directors first needs to pass an ordinary resolution to declare dividends (and record the fact in the Company records).
When you declare a dividend, you must provide each shareholder with a dividend voucher, which shows the type of shares held, the number of shares, the dividend amount, and the tax credit.
Shareholders will need the information contained on the tax voucher for the self assessment process.
Read our dedicated articles on how dividends are taxed and the paperwork required for dividend declarations for more information.
What happens if you declare an illegal dividend?
If you declare dividends where the retained profit is not available in the company, then you are trading insolvently, and your director’s loan account will become overdrawn.
This can lead to an HMRC investigation, penalties, and even the dividend being re-categorised as salary, subject to extra income tax and National Insurance Contributions.
Section 847 of the Companies Act 2006 states that if, at the time of the dividend distribution, the director knew that insufficient funds were available, then he/she must repay it to the company immediately.
Clearly, to avoid a situation like this arising, always ask your accountant first if you have any doubts over the level of dividends you want to distribute.
If you have declared a dividend incorrectly, also contact your accountant who will be able to advise how best to correct the error.
Further Information
You can read how HMRC treats ‘ultra vires dividends’ (illegal dividends) here.
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