Contractors, don't go mad with dividends between now and April

With many limited company contractors likely to be looking at their dividends before their £5,000 allowance gets pared back in April 2018, it makes sense to remember that excessive amounts can be drawn that become illegal dividends, writes Duncan Strike, director at Intouch Accounting.

Of course, most contractors rely on dividends from their company as the main source of income, after taking a small amount as salary from their company. However, the amount that can be taken is not the same as the cash held in the bank, and it’s easy to take too much. When you do, the excess is commonly called an ‘illegal dividend.’

In most cases it is a simple matter to work out the maximum dividend you can take. If you use an accountant then normally they can help. But more often nowadays, the information you need is easily accessible from many of the online accounting packages or the online systems provided by specialist contractor accountants.

Remember, a company will -- hopefully -- make a profit. Profit is the excess of income over expenses including salaries but excluding dividends. The profit is used to calculate corporation tax liabilities and the amount that is available as a dividend is often described as the accumulated profits after corporation tax has been deducted, less the accumulated dividends previously taken.

If the dividend being considered exceeds this amount then the excess is described as illegal.

What happens if you take an illegal dividend

Declaring illegal dividends is not a criminal offence, so you won’t go to jail because of them. If you failed to take “reasonable care” though, say by not preparing management accounts to check profits before declaring a dividend, then you may be responsible (legally) for repaying that dividend to the company.

If you have paid an illegal dividend then, provided it was an interim dividend, the easiest way to rectify it is to simply repay the money to the company. Or treat the excess as a loan to be repaid out of future dividends when profits exist, repaid in the future or left outstanding and subject to further corporation tax (called s455 tax, at the rate of 32.5%)

Fortunately, HMRC has provided some technical guidance supporting the repaying of an illegal dividend. So, turning to HMRC manual CTM20090, it says:

“Frequently the dividend is found to have been paid unlawfully. If that is the case, the company’s advisors will be able to rectify the situation by reducing or extinguishing the amount of the dividends and drawing up approved accounts showing only such amount of dividends as can be supported by distributable profits. Corresponding adjustments will be made to directors’ loan accounts, if the dividends have been credited to such accounts in the company’s books, or in draft accounts.”

To see the full context, read the full HMRC guidance here, and further guidance in Manual CTM15205) is available.

Dividend Waivers

Another potential dividend-related pitfall that contractors should be aware of involves the use of dividend waivers. There may be occasions where some shareholders waive their rights to receive income from a dividend distribution. This means that some shareholders will receive income, and others won’t.

Dividend waivers are a poor substitute for creating a more flexible shareholding arrangement and more carefully planning the capital structure of the company.

Belt & Braces

The best thing is to avoid all this and adopt a ‘belt and braces’ approach to your dividends, For example, protect yourself by preparing the correct paperwork for dividends and you’ll leave HMRC with little or no room to scrutinise or challenge you. The department hates director-shareholders who overdraw dividends, and so is known to tend toward treating unlawful dividends in any manner that maximises its tax take, so its officials often argue that excessive dividends are salary. Again, paperwork is your pal for stopping HMRC in its tracks. Minutes of a meeting approving the dividend, plus dividend vouchers sent to the shareholders will make HMRC's position very difficult to pursue, unless the Revenue can show that the paperwork was a sham.

Yet always remember that an unlawful dividend is a loan and if it isn't repaid within nine months following the end of the accounting year the company will have to pay (s455) corporation tax of 32.5% of the debt. Once the loan has been repaid, your company can get the tax.

Lastly, be aware that there are times when it’s better to take a loan than declare illegal dividends, especially when you are only temporarily in need of cash that would otherwise fall into the higher rate tax bands. For example, if you needed £10,000 cash and to declare a dividend within the higher rate band, would mean a personal tax liability of 32.5%, you would need to extract £14,815 from the company. Alternatively, your company could lend you £10,000 and pay 32.5%, a total cost of £13,250. It’s a short-term advantage of course, because at some point the loan does need to be repaid, but it’s always useful to know the option is available.

Final thought

Next year’s £3,000 cut in how much contractors can get in dividends within the nil rate band is making many consider their remuneration strategies now, often with the help of a dividend tax calculator (indeed, how to get the best out of such an online tool will inspire my next exclusive article for ContractorUK). But while this incoming blow highlights the need to keep on top of dividends received and the tax likely to be due, draw them very carefully.