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Uptick in companies drawing dividends unlawfully

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Director owner companies in the UK are continuing to draw dividends even when distributable reserves aren’t there to take out profits.

25th Jul 2023
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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.

Dividend entitlement

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.

Replies (8)

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By Justin Bryant
25th Jul 2023 16:02

If faced with this problem, don't the directors usually just argue it's actually salary to keep it out of the liquidator's grubby mitts?

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Replying to Justin Bryant:
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By rmillaree
26th Jul 2023 10:01

I suspect either by the time the liquidator questions things they dont really care - or companies are just left to rot with the issue never being looked at as to how company can make decent profits and still not afford to pay its corp tax. IMHO if company has paid divis and cant pay corp tax (and any associated s455 tax) 9 months after year end there is something seriously wrong - happens all too often though due to fact that no one really cares or stops them running business in such a manner. HMRC should be throwing the book at companies that pay divis and dont pay corp tax - they never do

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By ireallyshouldknowthisbut
25th Jul 2023 17:20

Out of interest where are these directors coming from?

ie do they have appropriately qualified professional advisors?

or are they using those heavy on the software, low on the thinking sausage machine outfits? Ie full of low skilled outsource labour who are just punching buttons? Some of that work is shockingly bad and I am not surprised the directors don't have clue as to their profit level, as they are shoveling in rubbish, and getting back further rubbish.

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By Hugo Fair
25th Jul 2023 18:38

".. some (self-employed contractors) may well lack a detailed understanding of what they are legally entitled to take as dividends" - I hadn't realised it was National Understatement week!

The majority that I've met have little understanding of anything 'accounting' beyond a cashbook ... P&L? (nod wisely whilst eyes glaze) ... Bal sht? (catalepsy alert!)

This is of course even more prevalent where contractor is unrepresented, but not a lot better with those that use one of those 'cheap as chips' agents just once p.a.

So how do you, Chris, see this being realistically improved when the taxpayer is caught between ignorance (blissful or otherwise) and an aversion to paying for regular professional guidance?

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By GHarr497688
26th Jul 2023 09:41

The system of dividends and salary for small companies needs reform . This was obvious when many private limited company owners couldn’t claim on dividend income . Government turn a blind eye and this article is further proof that small owner managed company dividends are just wrong !

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By petestar1969
26th Jul 2023 10:13

This situation has got a lot worse with the Bounce Back and CBILS loan schemes. I have a particular client who has overdrawn the profit for the third year in a row (to March 2023). The first year we were newly appointed and they "didn't know" they'd drawn too much as there was plenty of money around.

The business was struggling and they borrowed a lot and paid it to themselves as "dividends". I, of course, reclassified a big lump of it as directors' loans and they whined greatly about the s.455 tax but paid it.

Come to this year, same issue, borrowed more money to pay out as dividends. Client has now tried to order me to put more dividends through, I've said no and told them do it how I suggest or go elsewhere. Still waiting to hear from them (or their new accountants).

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By Joe Soap
26th Jul 2023 15:42
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