How to avoid illegal dividends
For HMRC to accept that you are paying dividends there are a number of hoops that you must jump through. In our experience few do this properly and are leaving themselves open to a big claim from HMRC.
Potential causes of illegal dividends
- Producing a set of accounts up to the date you decide the amount of dividend to be paid and checking you have sufficient distributable profits;
- Preparing a set of board minutes authorizing the dividend; and
- Issuing dividend vouchers.
Failure to do any of these steps could result in HMRC saying that you are not paying yourself a dividend (as you haven’t followed the right procedure) but are paying yourself a salary and therefore are liable for National Insurance. This is referred to as an ‘illegal dividend’. The National Insurance they claim is likely to be a whopping 25.8% that you wouldn’t be paying otherwise. The stakes are therefore big. So let’s go through each requirement in turn.
1. Producing a set of accounts and checking distributable profits
To pay a dividend your company has to have been making a profit and a sufficient profit to cover the payment of the dividend (called a distributable profit). You may have more cash than you have profit (perhaps because you got paid in advance) but you must not pay yourself out of this cash. The reason for this is because it is assumed that until you have recognized the sale and made a profit the money could be owed to someone else.
Let’s say you were to buy loads of stock on credit and immediately resell them. You should have generated a lot of cash but still owe your supplier. If you were to take all the cash outside the business then you wouldn’t have enough money to pay the supplier.
So quite reasonably you have to be able to prove that you are paying yourself out of profits. The only way to do this is to have a set of accounts prepared up to the date you decide to pay yourself a dividend, this will be monthly in most cases. A simple spreadsheet will suffice here but you need to remember to include a cost for tax. To do this it is best to assume you are going to incur a tax charge of 25% on your profits. You are hopefully going to be paying around 20% but 25% gives you a healthy margin of error.
Then from the remaining profits you can pay yourself a dividend. Note that all these calculations have to be considered on a cumulative basis. See the table below:
The business started trading in January 2011 and had an unusually high amount of expenses in that month connected with starting the business. From then on the business was comfortably earning £2,250 per month in profit after tax. It was only at the end of May 2011 that those losses in January 2011 were recouped.
It is not possible to pay a dividend until May 2011. Any dividend paid when the ‘Distributable profits c/f’ line is showing a loss will be an illegal dividend and risk being deemed by HMRC as a salary.
It’s difficult to prepare a spreadsheet for a generic company to use for these purposes. If you would like one custom made to your business then get into contact and we will happily prepare one for you.
2. Board Minute authorisation
The next step in paying yourself a dividend is the appropriate authorization by the Board. In all likelihood you are the only Director and Shareholder, which makes this slightly farcical but nonetheless per the Companies Act you must call a Board Meeting, attend it and prepare minutes.
Your minutes need to say that the Board considered the distributable profits of the company and deemed that it was possible and have authorized the payments of a dividend.
Here is what those minutes should look like:
Minutes of a meeting of Directors of [Company] Ltd held at [Registered Address] on [Date]
Present: [Director name]
Following consideration of distributable profits per the management accounts drawn up to [date] it was resolved the company pays a dividend of £[x] per each £ ordinary share on [date].
3. Dividend voucher
Finally, you need to complete a dividend voucher (also known as a dividend counter-foil). The voucher is basically a receipt. The one slightly awkward bit is that you need to include an amount of the notional dividend tax credit of 10%. You calculate the tax credit by taking the Dividend Payable and multiplying it by 10/9. See our dividend tax credit post for more info, but all you need to know for now is that you are still paying yourself a dividend of £2,250.
The example below assumes that your company has only one Ordinary Share issued to one Director and paying a dividend of £2,250 on 30 June 2011.
Dividend for the month ended 30 June 2011 payable to holders registered on 30 June 2011. Date of payment 30 June 2011.
Holding: 1 Ordinary Share
Dividend Rate: £2,250 per share
Dividend Payable: £2,250
Tax credit: £250
This voucher should be kept. It will be accepted by HM Revenue & Customs as evidence of a tax credit.
That’s all there is to it. It is pretty much just paperwork but you really need to ensure you are doing this or you could get a very big shock following a HMRC inspection.
If you are a contractor working through a Limited company read about how you might be impacted by IR35 in the next section of our dividend guide.
Caprica Online Accountants – Dividend guide
1. Advantages of paying yourself with dividends
2. Getting the right mix between salary and dividends
3. Understanding the dividend tax credit
4. The best way to time dividend payments
5. Illegal dividends and how to avoid them
6. IR35 and Dividends (for contractors only)
How Caprica Online Accountants can help
At Caprica Online Accountants we ensure all our clients have the right paperwork in place when taking a dividend as part of our great fixed fee online accounting packages.