Dividends are widely used among limited businesses, but they can come with ethical issues.

Many limited businesses utilise dividends because they’re more tax-efficient for directors than taking a salary. For shareholders, they act as a ‘thank you’ for investing.

But there are ethical issues associated with dividends.

Unlike taking salaries, dividends can only be paid if the business is making enough profit for equal distribution. In addition, a business must be in good financial health and in a position to meet financial obligations even after dividends are paid. It is therefore unlawful to pay dividends on a loss-making making business and one which is in financial difficulties.

As such, companies must meet the requirements as set out in the Companies Act 2006 or their dividend payments are considered unlawful.

Examples of unlawful dividend payments may include:

• paying out dividends despite insufficient company profits
• paying out dividends despite knowing the company will be unable to meet ongoing financial obligations
• failure to prepare interim accounts to support interim dividends
• inadequate paperwork or evidence to declare the dividend
• failure to pay all shareholders the same amount.

There have been several high-profile examples of unlawful dividend payouts. Former high street retailer Wilko infamously paid out £3m in dividends despite annual losses of £39m losses – it subsequently went into administration. Both Domino’s Pizza Group and retailer Dunelm have previously admitted to paying dividends which breached the Companies Act 2006 in 2015/16.

Accountants therefore play a crucial role in ensuring an ethical approach is applied to clients’ dividends and payouts are not in breach of the Companies Act 2006.

So what are the warning signs accountants should look out for?

Beware overly complex legal entities and share structures

Wendy Ross, Founder, & Laughton Ross, Director, Tonbridge Accountants

Deliberately not declaring dividend income is tax evasion which is both illegal and unethical. There’s no grey area here: if an individual receives over £10,000 in dividend income it needs to go in their self-assessment tax return. Smaller amounts can be dealt with through tax codes with the tax being taken from salary or pension income.

When it comes to paying dividends, the legal side of things can be very complex as directors have to consider company law and tax law. This includes:

Taking into account size and nature of the company. A large company with many shareholders should have a robust process, but can be simpler for smaller owner-managed businesses.

Determining whether the company has realised profits from which dividends can be paid. This will be straightforward for a company which dividends once a year as their annual accounts will show retained earnings. But it’ll be more challenging for a company which pays dividends frequently. For every dividend paid, the director needs to assess if profits allow dividend payouts and must also factor in tax due on profits, cash flow and whether it can meet financial obligations etc.

Documenting dividends via a vote at a shareholders meeting and issuance of a dividend certificate.

An alarm bell should ring if a client has an over-engineered or over-complicated legal entity structure or share structure. This doesn’t mean complex structures are wrong – but if a company had multiple legal entities in different jurisdictions, multiple share classes with different types of share and different dividend rights or complex profit-sharing arrangements, I’d want to dig into this.

Verdict: Overly complex legal entities and share structures with multiple share classes, legal entities in different jurisdictions and different dividend rights may be a bad sign.

Paying shares to family members is always a red flag

Beth Jackson, Founder, 2 Sisters Accounting

We find getting business owners to really understand the difference between dividends vs salary hard enough, let alone the full rules around dividends and what is and isn’t allowed.

Ultimately, unlawful dividends nearly always happen in small owner-managed businesses. We try and drill into our clients to save their tax as they go, leave a buffer in the bank account and then pay themselves to make sure they’re not going to be taking more in dividends than is available in profit.

A/B/C shares with spouses and children having shares is always an area we check into. Are family members actually involved in the running of the business? If not, should they really have shares? Especially B or C shares.

The changes in national insurance rates and the lower dividends allowance mean dividends are not the tax-efficient method of payment they once were. This may slowly change people’s attitudes towards them.

Verdict: Paying shares to spouses and/or children is always a red flag – if family members aren’t actually involved in running the business, should they really have shares?

Watch out for disguised dividends hiding excessive salaries or bonuses

Aftab Hussain, Accounting and Tax Expert, ANNA Money

A dividend can be paid to any person or entity that is a shareholder belonging to the company regardless of who they are, whether they have a role in the company or not. There are some important points to take into account, however:

A company should have enough accumulated profits tax to be able to cover any dividend. If there are no sufficient profits, then any dividends declared or paid above the profits level would be considered illegal payments. This would apply to any interim dividends during the year, too.

If a dividend is declared for a certain share class, all other shareholders in that share class must be paid an equal dividend unless they specifically waive their right to that dividend.

There’s a grey area when dividends are paid to shareholders who are also directors, especially if there are overdrawn director’s loan accounts. If the company pays dividends to clear a director’s loan, this might be reclassified by HMRC as salary, leading to additional taxes and penalties.

The main warning signs for accountants would be around insufficient profits. Also, where there is reason to believe that dividends are disguised as other payments. These other payments would normally be remuneration for services but are instead being made to shareholders under the guise of dividends. This would suggest an attempt to evade taxes.

Another example may be where a company has a complex structure set-up involving multiple other companies and companies which are shareholders instead of individuals. This would be an indicator that the true benefactor is trying to keep themselves hidden with a complex web of companies and would be an indicator of tax avoidance.

Verdict: Disguised dividends which may be hiding excessive salaries or bonuses are huge red flags.

Would you like to contribute to future articles like this one? If so, please get in touch with Annie Makoff-Clark at [email protected].

Annie Makoff is a freelance journalist and editor.