Am I at risk by overpaying dividends?

Contractor's Question: For the first financial year, dividends were taken that exceed the profit/loss for that year. In other words profit/loss after tax is £1,000 but £2,000 was taken in dividends, resulting in a loss of for the company. Now dividends should only be paid after 'p/l' and after taxation. What are the implications of this? Will it raise eyebrows within HM Revenue & Customs?

Following this, in the second year smaller dividends are taken, so, for example, the p/l after taxation is £10,000, but only £5,000 is taken in dividends. The company's reserves for the period are £5,000, so the company is back in profit. Is this normal, or allowed business practice? If it is not and HMRC will be suspicious, how can I fix the first financial year where there was a loss due to dividend overpayment?

Expert's Answer : Your concern relates to how HMRC will view excessive dividend payments and my response is therefore mainly focused on the tax aspects. There are issues under Company Law for you to consider which are not fully covered in this guidance.

Assuming the "dividends" taken in this case are just that (i.e. there is the necessary paperwork to support the voting of the dividend) and not just monies taken out of the company bank account by the shareholder / director ,which could be classed as additional salary / director's fees, then there are several issues to highlight.

Firstly if the director of the limited company, who is you in this case, was unaware that voting dividends in excess of its retained profits was breaching company law, then it may be possible to argue that the excessive £1,000 taken in year one is taxable as a dividend. It would then be prudent to limit future dividends to "replenish" the company's reserves, as you suggest. Tax issues aside, it is important to ensure the company does not have negative reserves as this could cause issues with third parties e.g. suppliers and banks. Remember your company's accounts are public records!

HMRC may however argue that the director of the company should have been aware that voting a dividend in excess of the company's retained profits was a breach of company law, in which case the payment will not be treated as a dividend for tax purposes. If this situation arose, the shareholder would either have to repay the dividend to the company or the dividend could be reclassified as a loan to the shareholder (if the shareholder is also a director of the company this will have associated tax consequences).

This is a relatively complex area and it is always advisable to seek specialist advice. This issue also highlights the importance of having accurate up-to-date company records throughout the year to ensure the directors of the company have all the information they need to make decisions on the distribution of profits to shareholders.

The expert was Martin Hesketh, managing director of Brookson, an accountancy firm for freelance contractors.