Understanding Director's Dividends

Company directors and owners could be falling into the trap of paying themselves illegal dividends, and as we come to the end of the financial year I think this is an important topic for me to cover. 

There has been a lot of attention on this matter after Sunil Bhavnani, a technical partner at Blick Rothenberg, spoke out, saying: ‘It’s common for directors of owner-managed businesses to pay a portion of their income as dividends and with the end of the tax year fast approaching, directors will once again be turning their minds to declaring an annual payment.'

‘The rules around dividends and distributions, governed by company law capital maintenance requirements and directors’ fiduciary duties, can be complex. If the requirements are not met such that the dividend is unlawful, the directors will need to act quickly.

‘A shareholder is required to repay an unlawful distribution if they know or have reasonable grounds for knowing that it was made unlawfully at the time of payment. In the case of a distribution made otherwise than in cash, the shareholder will have to pay the company a sum equal to the value of the distribution at that time.’

The 2006 Companies Act requires that any distribution can only be made where distributable profits exist and that is irrespective of the level of surplus cash in the business.

The amount of distributable profits is usually determined by the last set of financial statements which means that directors must consider changes in financial position and performance after the date of the final balance sheet. 

This is more important than ever after the impact that the Covid-19 pandemic has had on the earnings, financial stability and cash flow and balance sheet statements of many smaller businesses. This means that extra care will need to be taken to ensure that adjustments are made to any end-of-year financial statements, and may even call for directors to draw up interim accounts to allow them to re-evaluate their financial positions after the year-end. 

Some areas that will need looking at are:

• unpaid debts
• losses through surplus stock
• costs of sites that have remained unoccupied
• recognition of clients that are no longer financially viable

‘The directors will need to consider whether adjustments for such matters need to be made in any interim accounts for dividends paid sometime after the year-end.

As a business owner or director, you will also be obliged to safeguard the company's assets and pay all trade creditors and debts when they are due where possible. After a difficult financial year for businesses, some may be seeing a decrease in revenue, making paying back debts and other liabilities challenging. Which is another reason for frequent financial statements to be drawn up and not left until the end of the year. 

Bhavani put this nicely by saying: ‘Directors should consider both the immediate cash flow implications of distribution and the continuing ability of the company to pay its debts as they fall due. Directors must consider whether the company will still be solvent following a proposed distribution. Directors may be personally liable should the company become insolvent.’

For me, the devil's in the detail. However the detail is not something that accountants can now clear up at the year end. For us, it's crucial for clients to understand the necessity of real time financial data on either a monthly or at least quarterly basis to ensure that we don't fall foul of HMRC by paying an illegal dividend. We work closely with clients to ensure this doesn't happen to them