The difference between legal and illegal dividends

Dividends are like little rewards for shareholders – a way for companies to share their success and give something back to those who invest in them, writes Louise Rayner, founder of NumberMill Accounting.

But there are rules in place to ensure fairness and protect all those concerned, ranging from shareholders to HMRC! Let's dive into the world of these little rewards from a limited company contractor’s perspective and explore the difference between legal and illegal dividends.

Why dividends are like a high-five

Imagine being part of a company that's doing well -- financially. Dividends are like the high-five from that success. They represent a portion of the company's profits that is distributed to its shareholders. It's a way for companies to say, "Hey, thanks for investing in us – here's a little something extra for you!"

Legal dividends (aka ‘the right way to share’)

Legal dividends are the way companies properly distribute their profits while following the rules. There are three key conditions that must be met for a dividend to be considered legal.

Three conditions for legal dividends

1. Sufficient distributable profits

Before a company can pay dividends, it needs to have enough profits available for distribution. These profits include retained earnings and realised profits from the current or previous financial years, minus any accumulated losses and outstanding liabilities.

2. Staying solvent

Companies have a responsibility to make sure they can still meet their financial obligations, even after paying dividends. They need to consider their overall financial health and future obligations before making dividend payments.

3. Board approval

The company's board of directors is responsible for giving the thumbs-up to dividend payments. They should review the financial information, ensuring that the company can afford to distribute profits without putting its operations at risk.

Illegal dividends (aka ‘when lines are crossed’)

Illegal dividends are a bit like breaking the rules of a game! They happen when companies don't meet the legal requirements outlined by the Companies Act 2006. Here are a couple of situations that can lead to illegal dividends.

Two illegal dividend scenarios

1. Insufficient profits

If a company pays out dividends when it doesn't have enough distributable profits or goes beyond what's available, it's considered an illegal dividend. This can put the company's financial stability at risk and harm the interests of creditors.

2. Endangering solvency

Companies that pay dividends despite knowing they won't be able to meet their financial obligations can find themselves in hot water. These kinds of dividends can be seen as illegal, as they jeopardise the company's solvency and hurt the rights of creditors and other stakeholders.

Consequences of illegal dividends

The consequences of distributing illegal dividends can be serious, so watch out!

Directors may be held personally responsible and could face legal action from shareholders, creditors, or regulatory authorities. Courts can order the repayment of illegal dividends and may even impose fines or penalties on the company and its directors.

The dividend role a director plays…

Directors play a crucial role in ensuring dividends are distributed correctly.

They have a fiduciary duty to act in the best interests of the company and its stakeholders. When it comes to dividends, directors must exercise caution and diligence. Keeping accurate financial records, regularly assessing the company's financial position, and seeking professional advice when in doubt, are all part of the director’s job.

Final thoughts

Dividends are the reward you gain for being a successful business.

But your dividends as a contractor must follow HMRC’s rules to ensure fairness and maintain the integrity of the corporate world.

Legal dividends spread the wealth while protecting the interests of all parties involved. On the other hand, illegal dividends can lead to trouble, causing legal and financial headaches!

By understanding the difference between legal and illegal dividends, directors, shareholders, and everyone in the corporate ecosystem can maintain compliance and foster a friendly and transparent environment for sharing success.