Dear Contractor Doctor,
I’m a limited company contractor and I am both the director and sole shareholder of my company. On reconciling my profit for the year I have calculated that I paid myself a dividend that is in excess of the profit made by my limited company.
How can I account for the overpayment of dividends?
Contractor Doctor says:
“Most contractors would not have this issue. But within my client portfolio, there are usually a handful each year who have accidentally paid out illegal dividends – so it’s not uncommon,” says James Abbott, owner and head of tax at contractor accountant Abbott Moore.
“The difficulty is that the shareholder and the director are the same person in most contractor businesses. Therefore, when a shareholder takes an illegal dividend, you would naturally assume that they should know that there aren’t sufficient profits available.”
Abbott explains that contractors typically overpay dividends as a result of one of two scenarios. One may be that, as the director, the contractor hasn’t taken the necessary steps to ensure that the profits are available. The other scenario might be that the dividend was overpaid as a result of a genuine error. This is particularly the case with smaller businesses, who don’t tend to keep the detailed records that a larger company would.
Whilst less common, Abbott adds that some contractors overpay dividends as a result of an oversight, such as forgetting to account for the 20% corporation tax that is deducted from company profits before dividends are paid out. Fortunately, errors such as this are fairly easy to reconcile.
Overpaid dividends should be treated as loans
Company law dictates that, if a contractor has withdrawn a dividend that exceeds their company profits, the overpaid dividends need to be treated as a loan to the shareholders, which must be repaid. Abbott adds that HMRC acknowledges that illegal dividends can occur and sets out the treatment in its Company Taxation Manual.
Taking a loan in this manner incurs two tax impacts. Firstly, if the contractor is also a director of the company and the loan is in excess of £10,000, they have to pay tax on benefits in kind (BIK) on the notional amount of the interest.
“So, very broadly, if you have an interest-free loan of more than £10,000 from a company that you’re either a director or an employee of, you are taxed personally on the amount of the loan at a given interest rate – which is currently 3%,” Abbott explains.
However, contractors are also required to repay the loan within nine months and one day of the end of their company accounting year, or else their company will be charged a temporary tax of 32.5%, known as section 455 tax. This tax is recoupable upon full repayment of the loan, but it is subject to complicated rules and may be some time after repayment. Abbott explains that the temporary tax was introduced as a deterrent for contractors who might otherwise gain from the tax-efficiencies of withdrawing a tax-free loan.
“If you consider your options, you can either withdraw money as a dividend and get taxed on it, or you can take a potentially tax-free loan. Inevitably you’re going to opt for the latter, so this is why the temporary tax exists.”
“Measures to avoid dividend overpayment
Although contractors have ample time to correct a dividend overpayment once they have discovered the oversight, it is still an error that they should always seek to avoid. Abbott highlights numerous measures that contractors can take to avoid overpaying dividends:
“Firstly, contractors need to ensure they understand the rules. Make sure they understand how profits are calculated for dividend purposes and the fact that the figures need to be considered after expenses, salary and corporation tax.
“Secondly, contractors shouldn’t withdraw every penny they feel is due. I encourage my clients to leave a buffer behind to mop up any potential discrepancies. Then at the end of the company year, once the accountant has worked out the correct figures, the contractor can then take out the extra money that they know is there to take.
Abbott adds that an annual forecast calculation of dividends allows for full consideration of each determining factor. This includes the contractor’s anticipated earnings, estimated salary and expenses and corporation tax:
“If you try and do your dividends monthly, there are just too many complications going on. You’re better off working off an estimate and allowing a bit of headroom.”
Responsibility rests with the contractor
Finally, whilst the contractor’s accountant may in some instances flag up that the contractor is attempting to take an illegal dividend, the onus is very much on the contractor to carry out due diligence with regards to their own accounts.
“Ultimately, the accountant’s responsibility is to ensure their client understands the rules,” Abbott explains. “The contractor is the person running the company. They have the ultimate decision over how much money to take out.”
Abbott adds that contractors who have their accountants carry out extensive duties with regards to their company finances – such as performing more accurate dividend calculations – place themselves at risk of falling subject to the managed service companies (MSC) legislation.
“If your accountant is doing more than advising, there is always a risk,” Abbott concludes. “So it is imperative that the contractor assumes responsibility and keeps a keen eye on their company finances.”