Paying dividends is a common way for company owners to extract profits — but what if the company doesn’t have sufficient profit to legally justify the payment?
When this happens, the dividend becomes what’s known as an “illegal dividend” (technically called an unlawful distribution) and both the company and the shareholder — especially if they are also a director — could face serious tax implications.
Let’s break down what this means and how to protect yourself from the financial and legal consequences.
💼 What Is an Illegal (Unlawful) Dividend?
Under Company Law (Companies Act 2006), dividends can only be paid out of accumulated realised profits, minus any accumulated losses. This means:
- Even if the company made a loss this year, dividends can still be paid if past retained profits are available.
- If there are losses carried forward, even a current-year profit may not be enough to justify a dividend.
So, if a dividend is paid when there are insufficient distributable reserves, the company is in breach of the law — effectively trading while insolvent.
🧾 What Are the Tax Consequences for the Company?
If HMRC or a liquidator determines that a dividend was unlawful:
🔸 The dividend is void
The company must treat it as if it was never paid.
🔸 The shareholder may need to repay the amount
If the shareholder knew or should have known the dividend was unlawful, they must repay it — either fully or proportionally, depending on how much of the dividend exceeded available reserves.
🔸 Loans to participators charge
If the dividend is not repaid, and the shareholder is also a director, the amount may be reclassified as a director’s loan under section 455 CTA 2010:
- A tax charge of 33.75% of the loan applies if it’s not repaid within 9 months and 1 day after the year-end.
- This charge is still payable even if the company is loss-making.
- The tax is refundable if the loan is repaid later — but this may take years.
👤 What Happens to the Shareholder/Director?
🔹 Exemptions
The loan charge does not apply if the director:
- Owns less than 5% of the company, and
- The loan is less than £15,000, and
- They are a full-time working director
🔹 Employment-related benefit
If the loan is over £10,000, HMRC treats it as an employment-related benefit. This means:
- The director receives a beneficial loan, and a benefit-in-kind arises.
- A P11D must be filed.
- The company is liable to pay Class 1A National Insurance.
- A notional interest charge (currently 3.75% p.a.) is applied to the unpaid balance.
🔹 Formal loan write-offs
If the company decides to write off the loan:
- It is still classed as income for the director
- It may also be taxed as a dividend or employment income, depending on the circumstances
🧨 Liquidation Consequences
Things become far more serious if the company enters liquidation or administration.
- The liquidator or administrator is legally required to investigate dividend payments made in the three years prior to insolvency.
- If an illegal dividend is discovered, they can apply to recover it from the directors or shareholders.
- The time limit for recovering unlawful dividends is six years from the date of payment.
In some cases, directors may be held personally liable if they’ve breached their fiduciary duty to the company by approving the dividend.
💡 Practical Tips for Company Directors
- Always check your retained profits before declaring a dividend — don’t rely on the bank balance alone.
- Maintain proper board minutes and dividend vouchers to prove the decision was made responsibly.
- If your accounts show negative reserves, avoid paying dividends — HMRC can detect this easily via your digital tax return.
- Seek advice if you’re unsure whether a dividend is lawful.
🚨 HMRC and Illegal Dividends
It’s increasingly common for HMRC to challenge dividend payments made when company accounts show negative reserves. They can pick this up through iXBRL-tagged accounts filed with your Corporation Tax return.
Even if the business is struggling, directors must prioritise financial due diligence and only pay dividends when legal to do so.
📌 Summary
| Situation | Consequence |
| Dividend paid without sufficient profits | Considered unlawful |
| Shareholder/director receives it knowingly | Must repay it |
| Not repaid | Triggers Section 455 loan charge (33.75%) |
| Over £10,000 loan | Benefit-in-kind, P11D, Class 1A NIC |
| In liquidation | May need to repay the dividend personally |
| Formal write-off | Still taxed as income |
⚖️ Final Thought
Paying yourself through dividends is tax-efficient — but only when done correctly. Failing to follow the rules can lead to hefty tax bills, NIC liabilities, or worse — personal liability in insolvency.
If you’re unsure about whether you can legally pay or retain a dividend, it’s wise to seek professional advice from your accountant or tax adviser.
Partner note:
CTA 2010 s 455
CA 2006 s 830(2)
CA 2006 s 847
CTM15205
Limitation Act 1980, s 5
