When dividends go bad: How limited company directors can face a personal tax liability

The question of how ‘bad’ dividends can land a limited company director with a personal liability to HMRC is worth asking, because it goes against the grain of what most people regard as a key motivator to having such a business, writes Matt Fryer of Brookson.

The status quo of ‘LTD’

One of the main reasons that a contractor considers setting up their own limited company (in addition to the perceived tax benefits) has always been the concept of limited liability.

In its simplest terms, the liability of the director (who is generally the majority shareholder) for a company’s debts is limited to any amounts that remain unpaid on their shares in the company, and they are not liable for a company’s debts in certain cases. This means that their personal assets are protected, even if the company becomes insolvent while having outstanding debt.

The key here is that in certain cases, such as taking ‘bad’ dividends, the concept of limited liability may be put to one side, meaning directors could be personally liable for company debts if excessive dividends are paid, which in turn leads to financial difficulties for the company and its creditors.

What is a ‘bad’ dividend?

Dividends are unlawful (or illegal) when insufficient profits exist within the company to cover the amounts paid.

Illegal dividends are also referred to as being “ultra vires” which means “beyond the powers.” In this respect, the director does not have the power to authorise such a payment from company funds.

Essentially when paying a dividend (and documenting payment details on a dividend voucher), the director needs to have satisfied themself that the intended dividend is covered by:

· Retained profits from the last annual accounts;

· Those profits not becoming ‘lost’ in the intervening period of the current interim accounts.

Crucially, contractors should not pay a dividend if it leaves the company being unable to pay its future debts as they fall due, such as its approaching corporation tax liability.

What are the potential repercussions of bad dividends for limited company directors?

It should nowadays go without saying that a director has legal and general duties, which includes ensuring no improper activity is undertaken by them, including the inappropriate use of dividends and unauthorised remuneration to directors, either of which risks leading to insolvency and to the detriment of creditors.

HMRC’S view is that excess dividends, which would create a deficit on the company’s balance sheet, should be treated as a loan to the director, rather than dividend income and that the director should have known that the dividend was illegal.

In the majority of cases, HMRC is the principal creditor and where significant amounts are involved, the worst-case scenario is that HMRC would look to seize personal assets to recover the amounts owed to the company which were unlawfully taken out of the company as dividends. The HMRC action would be designed to, ultimately, settle the outstanding company tax bill by approaching the director and his/her assets.

How to correct a wrong dividend payment

For small companies, being aware of your business’s financial position at all times is key to ensuring ‘bad’ dividends are not paid in error, as that would leave the company open to cashflow issues in the future.

Utilising bookkeeping services that allow you to see in real time your current cashflow position, does safeguard directors to some extent. Also, where dividends have been inadvertently taken in error, leading to a short-term deficit on the company balance sheet, then documenting a ‘repayment plan’ by reducing dividend payments going forward (or looking to repay cash directly into the company) to return the company to a solvent position should be considered.

However, where companies are at risk of insolvency and unlawful dividends have been withdrawn, leaving no recourse for settlement of company liabilities, the risk to the director of being personally liable does increase.

Final warning

In this respect, insolvency practitioners do review a company’s dividend history (among other things) to determine if a claim is to be made against the directors/shareholders. If HMRC is owed significant amounts, the tax office’s course of action will be decided independently and as result, bad dividends will land a company director with a personal liability.