Running a limited company comes with its challenges and responsibilities, not least managing the company’s profits and finances. Whilst one of the most tax-efficient ways of paying a company director is through a small salary and dividends, it is important to remember that dividends are a distribution of company profits, and continually paying more dividends than company profits can lead to serious consequences further down the line.
If a company pays out more dividends than it can afford, the excess amount must be returned to the company or be added to the director’s loan account as a debt from the shareholder to the company. Having an overdrawn directors loan account can result in both income tax and corporation tax consequences.
In this blog post, we will look at the potential pitfalls of overpaying dividends and what best practices to adopt to avoid financial difficulty.
How are dividends usually paid out?
Businesses have the option to pay two types of dividends: interim and final dividends. Interim dividends are payments made during the financial year, while final dividends are paid after the financial year, usually once the company’s accounts have been completed. Typically, owner-managed businesses will distribute interim dividends throughout the financial year.
It is important to remember that dividends are a distribution of retained profits, so before paying dividends, it is a director’s responsibility to make sure that there are enough available profits to cover any dividend paid. Retained profits include any retained profits brought forward from previous financial years and profits in the current year.
It is the company director’s responsibility to declare dividends payable to the shareholders and to make payments. These payments are separate from any salary payment, and a dividend voucher should be prepared for the amount paid to each shareholder.
Can a company pay more dividend payments than its profits?
In most cases, no, a company can’t pay more dividends than it has in profits. There has to be enough retained profit within the company at the point of declaring the dividend to cover the dividends being paid.
If the financial position of the business deteriorates after an interim dividend is paid, then management accounts must be prepared to demonstrate that enough profits were available at the point the dividends were paid.
Overpaying dividends makes them illegal, which carries its own consequences, but overpaying dividends can also leave a business financially vulnerable. If future sales decrease, a lack of profit could cause cashflow issues, debt accumulation and, in extreme cases, insolvency.
For further reading on this, see our blog postWhat are the rules for overdrawn director’s accounts?
Who do you declare overpaid dividends to?
When a company pays dividends in excess of its profits, these dividends are considered unlawful. Therefore, they are not declared like other company dividends. The overpaid amount is added back to a director’s loan account as a debt that is due to the company. This debt is recorded on the balance sheet until the shareholder pays the amount back to the business.
If this amount is not repaid by the company’s financial year-end, the amount is disclosed in the annual accounts submitted to Companies House.
Whilst taking excess dividends is not a criminal offence, getting out of an overdrawn loan account position can lead to financial difficulties and cash flow challenges.
What taxes are incurred when dividends are overpaid?
A director can maximise their pay by taking a smaller salary and dividends combined, allowing them to make the most of their personal allowance and tax-free dividend allowance.
Whilst this is the most tax-efficient way of structuring a director’s pay, taking excess dividends has implications on both the director’spersonal taxand the company’s tax liabilities due to the loan account being overdrawn.
Let’s take a look at each tax implication.
Corporation Tax
If the unlawful dividends result in an overdrawn directors loan account and they are not repaid within 9 months of the year-end, then an S455 charge may be payable. An S455 charge is a Corporation Tax payment on account at the prevailing higher income tax rates for that tax year. The current rate is 33.75%.
For instance, let’s say a director receives a dividend of £30,000, which is later found to be unlawful. In that case, when preparing the accounts for the year ended 31st March 2024, if the said amount is not repaid to the company by 1st January 2025, an additional £9,975 will be due along with the company’s Corporation Tax bill.
Benefit-in-kind
If the amount owed to the business is less than £10,000, there are no benefit-in-kind tax implications. However, if the amount due is over £10,000, the company has two options. It can either charge interest to the shareholders or apply a benefit-in-kind charge on the interest-free element of the loan.
Income Tax
From an Income Tax perspective, the director or shareholder in receipt of the unlawful dividend will pay tax on it as a benefit-in-kind if the director’s loan account is over £10,000 as a result of disallowing the dividend.
Get on track with Spotlight Accounting
The key point from an accountant’s point of view is that directors must have a clear sight of their profit margin before considering issuing dividends.The team at Spotlight Accountingcan help get you on track in a number of ways, such as robust financial management using Xero and regular management accounts.
If your company has overdrawn directors loan accounts, we can help you devise a repayment plan to avoid financial setbacks come year-end.
Please get in touchwith us if you think we could be of benefit to you and your business.
Conclusion
Dividends cannot be distributed by a company if they are in excess of company profits. If they are, they are considered unlawful dividends and must eventually be paid back to the business.
Excess dividends can leave a company financially vulnerable, as there are potential tax consequences for the company and shareholders.
It is vital that company directors have an accurate view of company profits before declaring company dividends and an understanding of how to repay illegal dividends.
Frequently asked questions about paying out more dividends than company profit
Can a company pay dividends if it doesn’t make a profit?
In general, dividends cannot be paid if the business incurs a loss for the period. However, if the company has enough retained profits from previous periods to cover the loss and the dividend payment, then dividends may be distributed to shareholders.
Are dividends guaranteed?
Dividends cannot be taken for granted as they are not guaranteed. They are paid by a company only when it has made a sufficient profit. In other words, if a company is unable to make a profit, it will not be able to pay dividends to its shareholders.
