Uptick in companies drawing dividends unlawfullyby
Director owner companies in the UK are continuing to draw dividends even when distributable reserves aren’t there to take out profits.
At the start of each financial year, business owners must assess the most efficient means of remuneration. Often, this is a mix of salary and dividends – with hundreds of thousands of off-payroll freelancers accustomed to topping up their salary by drawing dividends to minimise their personal tax bill.
However, if director owners fail to keep on top of remuneration planning and changing tax legislation, they not only risk a higher tax bill but could stray into an age-old trap whereby dividend payments outweigh profit, leaving no distributable reserves available.
While drawing dividends is a valid commercial approach during good times, if trading performance takes a turn for the worse, these dividend payments could be unlawful and can be subsequently clawed back if the company cannot avoid formal insolvency.
Uptick in insolvencies
Following a recent uptick in formal insolvencies following the pandemic, we are coming across more cases of this than usual.
The latest government insolvency statistics for June 2023 reveal there were 2,163 company insolvencies, 27% higher than in the same month in the previous year (1,698 in June 2022) and higher than pre-pandemic numbers.
There were 260 compulsory liquidations in June 2023, 77% higher than in June 2022, and 1,759 Creditors’ Voluntary Liquidations (CVLs), 21% higher than in June 2022. Administrations and Company Voluntary Arrangements (CVAs) were also higher than in June 2022.
The uptick in insolvencies is particularly prevalent with Personal Service Companies (PSCs).
While self-employed contractors may well be excellent at the service they provide, some may well lack a detailed understanding of what they are legally entitled to take as dividends. This is especially the case if they rely on dividends instead of a PAYE salary for tax purposes, which includes not paying national insurance contributions on the dividends and not having tax deducted at source.
They are reliant on their professional advisers to warn them of such pitfalls. However professional advisers are often working on historic data and by the time the issue is identified, it is too late. The simple fact is that director shareholders are not entitled to dividends if distributable reserves on the annual balance sheet aren’t there to draw down on profits.
No excuse for financial ignorance
In our digital age, there is no excuse for financial ignorance – the technology and software is available to provide real-time management information. Failing that, the director should be able to pull off manual monthly reports to show whether there are surplus net assets after accruing for all liabilities each month.
We are seeing many instances where companies don’t have proper processes in place to protect themselves if the trading dashboard starts flashing orange or red.
Concerned director owners should seek professional advice at the earliest opportunity when, firstly, they see a sustained drop in profitability, and, secondly, their balance sheet capital reserves are heading towards zero. If caught early enough, the unlawful dividend trap can be averted and the chances to turnaround or restructure the business are improved.
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Chris Tate is the restructuring and recovery partner with UK top ten accountancy firm Azets.
He is a Fellow Chartered Accountant and licensed Insolvency Practitioner with over 19 years experience in Restructuring and Insolvency. He has worked on a wide portfolio of corporate and personal insolvency matters in various industries including...