Small business owners will often draw funds from their company as a combination of salary and dividends. For most this works perfectly well and ensures that tax liabilities are minimised.
However, when things go wrong and a formal insolvency ensues, significant problems can be encountered.
The Companies Act 2006 states that dividends are only to be paid out of profits available for the purpose. Unfortunately many business owners misunderstand this point or are unaware of it at all.
The profits which are available for distribution will generally be determined by the company’s last accounts prepared and filed in accordance with the Companies Act.
It is possible for dividends to be paid based on interim accounts but the correct procedures for preparation of such accounts and the distribution of profits must be followed in order for the dividends to be valid.
Following a formal insolvency event, such as liquidation or administration, it would be unusual for profits to have been made in the period between the production of the last accounts and the insolvency event. Therefore any dividends paid in respect of that period of trading would be unlawful, to the extent that previous profits had not been retained, and repayable by the recipient to the company.
Business owners tend to pay themselves regular dividends on a monthly basis instead of receiving (or in addition to a low level of) salary. The payments would ordinarily be allocated to a director’s loan account and then offset against dividends distributed from profit when the next accounts are prepared. In successful trading periods this works well and reduces the tax burden on the company in addition to reducing the owners’ personal liability.
However, when profits are not subsequently realised, the effect is that the dividends paid must be returned to the company and the business owner will be left in the position of not having been remunerated for their endeavours during the period. It may well be the case that the funds received are no longer available to repay and this leads to personal assets being at risk.
It is therefore vital that business owners regularly review the trading position and ensure that dividends are only paid out of distributable profits. It follows then that business advisors have an important role to play in ensuring that their clients are fully aware of the implications and are assisted in preparing the appropriate accounts regularly and making correct provision for the payment of business owners.
The value of a good accountant should not be overlooked. Losing your business in the event of insolvency is bad enough but being asked to repay what you have earned in the preceding period is a very bitter pill to swallow.
The key to avoiding this potential problem is to take advice at the earliest opportunity. The sooner advice is taken the more options will be available to take corrective action or prevent the problem from arising in the first instance.
Written by Michael Durkan, Durkan Cahill