Dividends Overpayment: Are you leaving enough money in the company?

I’m not sure whether it’s the current financial climate or owners simply not understanding the rules or even the accountancy advice is non-existent, but in recent months we’ve noticed a growing trend on new sign-up companies that have been drawing out too much money from the bank account and leaving themselves in trouble at the year-end.

What I am talking about is the payment of ‘dividends’ from the company in excess of the available profits. The current trend of a small limited company is usually to take a minimum wage and the rest as dividends from the profit earned – that’s usually the best tax efficient way. However, what an owner does not realise is the available profit is calculated after tax, not before.

How does it happen?

Let’s take an example….an owner needs £40k per year to live based upon current lifestyle activities. At the year-end the accounts are prepared and the company makes £40k in profit (before tax). The owner has simply taken out all the money from the business without realising. On £40k profit the corporation tax payable is £8k which means legally (assuming no previous year reserves) the available amount of dividend is actually £32k. They have taken £8k too much!

The problem is that the company could have to pay up to 25% in tax on any overpayment of dividends. In this case, it’s £2k!

How can this be monitored?

Regularly using an accounting system can usually help the owner (or accountant) calculate how much dividend is available to take. However, this only works if the accountant’s support is pro-active and timely. So what other indicators could be used to warn the owner of overpaid dividends?

  • Look at previous year’s accounts:  if you had the same problems in the previous year and income has not changed, you’re probably going to have the same problem again – but this time doubled!
  • Can you afford to pay last year’s tax bill?  Generally, if you have insufficient money in the account to pay your taxes (unless your business income is significantly up and down) then it’s likely you’ve taken out too much.
  • Is the bank balance always reducing?  If at the end of the year the company bank account is significantly lower than at the start and there are no (or relatively) few outstanding payments (debtors or creditors) then it could be you have taken out too much.
  • Struggling to pay creditors?  If you are struggling to pay VAT, PAYE or other taxes but business profits are unchanged then it’s likely you are taking out too much
  • Gut feeling?  I am sure many owners think they are taking too much money out and they are probably right in most cases!

How can this be corrected?

It can be difficult to get back onto the straight and narrow with the company finances but what can be done to rectify it quickly?

  • Pay the money back to the company.  Easier said than done but ultimately if you have taken it out, you’ve got to put it back!
  • Reduce the amount you take out in the future.  By reducing the amount of dividend you take out over time you could potentially generate enough ‘spare’ profit to declare a dividend and offset against the outstanding amount owed.

Taking too much money from the company is potentially a very serious action and can nullify the ‘limited liability status’ of your company.  This means that creditors (including HMRC) could come knocking on your door for the money back!

Posted by Chris Mollan