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Dividends and profits

Dividends and profits
Views: 954
Date: 14th Dec 2011

In order for a dividend to be lawful it must comply with company law requirements. A key requirement is that the company must have sufficient profits to finance the dividend.


What happens in practice

In many if not most small limited companies, the directors are also the owners of the business and will extract cash from the company in the form of a dividend. Often directors draw cash from the company during the year and the resulting balance on their loan account is cleared by a dividend at the year end. The following highly simplified scenarios illustrate this approach. To keep it simple in each case:

• the director is a 100% shareholder of the company and has a zero balance brought forward on his current account
• the director has drawn £30,000 from the company in the year
• there are no profits brought forward
• the corporation tax rate is 20%

Scenario 1

Pre tax profits for the year - £37,500
Corporation tax - £7,500
Post tax profits - £30,000
Dividend of £30,000 clears directors current account
No issues arise

Scenario 2

Pre tax profits for the year - £30,000
Corporation tax - £6,000
Post tax profits - £24,000
Dividend of £24,000 leaves directors current account overdrawn by £6,000
The following issues arise:
• the £6,000 is deemed to be an “interest free loan”. Notional interest on it needs to be calculated and declared as a P11d benefit upon which the director will pay personal tax
• if the balance is still outstanding nine months after the year end there is an additional tax charge on the company of £1,500 (25% of £6,000). This will be repaid to the company but only nine months after the end of the accounting period in which it is repaid

Conclusion

In the current economic climate I think it entirely likely that directors that have previously only ever experienced Scenario 1 may find with falling profits that they fall within Scenario 2. Avoid this by knowing your profit levels on an on going basis and reduce your drawings accordingly if necessary!

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