Where trying to save money can cost you dearly

Most owners of small limited company businesses are doing all they can to save money right now.  Many do so by taking the bulk of their drawings from their company by way of a dividend rather than remuneration through the paye system.  They do this because it saves national insurance, a large and growing number.  However, this is not without risk because unless they follow all the procedures for legally doing so (and most owners have no idea what the procedures are!), if the company later goes into liquidation or administration its insolvency practitioner will simply ask for the money back.  In broad terms, as  the dividend payments are made an overdrawn director’s loan account is created (an amount the business owner owes to the company).  However as the credit entry writing this off either is invalid, because the procedures to validate it have not been followed properly, or the entries have not been made (for example with late dividend payments), the debtor balance is repayable.  And there is no margin for error, mistake or omission in the procedures – you either get them right or not.

Let’s go back to a few basic principles arising from the statute and case law on this subject:

  1. The law requires that all administrators and liquidators investigate companies over which they are appointed.  One of the purposes of that investigation is to ascertain whether monies could be recovered for the benefit of creditors.  The insolvency practitioners’ prime duties are owed to the creditors, not to you the director/shareholder of the company.  One source of potential recovery of assets is from you, if you have taken illegal dividends.
  2. Dividends can only be paid out of distributable profits.  In broad terms this is the balance shown on the company’s balance sheet for its ‘profit and loss account’ – the total profits (less losses) you have made over time but not paid out.  If the company does not have a positive profit and loss balance, then you cannot legally pay yourself a dividend.  If you do so, the liquidator or administrator will ask you for the money back because all you have done is create an overdrawn director’s loan account.
  3. Assuming your company has ‘distributable profits’, you still have to go through several legal hoops, and at the appropriate time, to be able to safely draw dividends from them.  You cannot go through these hoops later on, after the company has gone into insolvency as one accountant recently tried on a case I am dealing with – again you will be asked for the money back.  Insolvency practitioners see many cases where the paperwork doesn’t exist because the paperwork has been left for the accountant to sort out when he prepares the annual accounts.  Often the company goes into liquidation before the paperwork is prepared.
  4. Accounts have to be drawn up on a proper basis proving that the company has sufficient distributable profits to pay the dividends – these can either be the previous year’s filed accounts or more recent management accounts but either way, they have to be drawn up using proper accounting principles – a ‘back of a fag packet’ exercise will simply not do.
  5. Having demonstrated the company has sufficient distributable reserves to pay the dividends, you then have to hold a meeting of the members authorising its declaration and payment.  This meeting has to be properly recorded, even if you are the sole shareholder!  If it is not properly recorded, any dividends you have taken will be illegal and repayable.
  6. Those minutes have to show that you have properly considered the effect of the dividend on the future viability of the company.  If the dividend leaves the company in a weakened financial position, prone to collapse, it can be upset by the insolvency practitioner: you could see yourself sued for misfeasance (the courts have held that the taking of excessive dividends gives rise to an action for misfeasance) and you could also be banned as a director.  This is because the reasonableness of your actions will be assessed by both the insolvency practitioner and BERR, and if you have not done as the man on the Clapham omnibus would have done under the circumstances, if your actions have exposed the company’s creditors, you will be held accountable.

In conclusion, there are real drawbacks to taking dividends from a weakened company.  Most small business owners simply go into these things blind, thinking that they can what monies they like from their company how and when they want and somehow backfill later, deferring the paperwork to their accountant.  To do so is very risky indeed.  To reduce the risks of personal attack from an insolvency practitioner or the Revenue, all the right procedures have to be gone through at the right time, and that costs money, eliminating some of the savings made.   On a practical level an insolvency practitioner will not query your reasonable remuneration passing through the paye system but he will look to you to repay even small amounts of dividends paid illegally.  And he will always report illegal dividends to the DTI, who could ban you from being a director.  And he could sue you for misfeasance.  But it’s even worse than that!  HM Revenue & Customs could also ask you to personally pay the tax on the money you have taken from the company – they can treat the money paid to you as net remuneration and gross it up.

If you go to an accountant on the basis of expense in an attempt to save money, and as a consequence you do not work closely with him/her and fail to do all the right things at the right time to record and justify any dividends you take, you are risking yourself unnecessarily.  It’s far better for you to merely pass your drawings through the paye system and pay over the tax.  This is yet another instance where scrimping on professional support or picking the wrong accountant can cost you very dear indeed.

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One thought on “Where trying to save money can cost you dearly

  • June 11, 2011 at 8:38 pm

    Great article, however it is mainly concered with the recoverability of illegal dividends, and doesn’t go into detail about legal dividends that can still be challenged by the IP as a Preference.

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