What it means
The consequences fall on the people who approved the payment. Directors can be required to repay the amount personally, and shareholders who knew or ought to have known that the distribution was unlawful can be ordered to return the cash.
That personal exposure is what makes the topic more than an accounting technicality. Two tests are commonly applied before any dividend is declared.
The profits test asks whether accumulated realised profits, less accumulated realised losses, are large enough to cover the payment. The solvency test asks whether the company will still be able to pay its debts as they fall due for a period afterwards, typically the next twelve months.
In practice the board should look at recent management accounts rather than a year-old audited balance sheet before declaring anything. Interim dividends are the classic trap, because trading may have deteriorated badly since the last accounts were signed.
Recording the reference accounts and the solvency assessment in the board minutes is cheap protection if the payment is later questioned. Owner-managed companies encounter the problem most often.
Drawings are taken monthly for living expenses and only labelled as dividends when the accountant prepares the year-end file, by which point the profits may not exist to support them. Those payments are then recharacterised as loans to directors or as salary, each with its own tax consequences.
The situation is usually fixable if caught early. Repaying the excess, formally waiving the dividend before it is paid, or capitalising it as a director's loan on proper terms are all far cheaper than arguing about it after an insolvency practitioner has been appointed.
Lenders also care, because an unlawful distribution can breach loan covenants and trigger a demand for repayment.
In practice
Real-world examples.
Example
A consultancy pays its two director-shareholders $8,000 a month each as dividends. A weak final quarter leaves full-year profits of $150,000 against total dividends of $192,000, so $42,000 must be repaid or reclassified as a director's loan.
Example
A trading company declares a dividend based on last year's audited accounts without checking current performance. Interim management accounts prepared later show a loss for the period, and the auditors flag the distribution as unlawful in the following year's file.
Example
A company sells a property at a large accounting gain but has not yet received the cash. The board wrongly treats the unrealised revaluation surplus as distributable and declares a dividend against it, which fails the realised profits test.
Formula
Calculation
Distributable Profits = Accumulated Realised Profits - Accumulated Realised Losses
Unlawful Portion of a Dividend = Dividend Declared - Distributable Profits
A private company has total assets of $3,000,000 and total liabilities of $2,300,000, giving net assets of $3,000,000 - $2,300,000 = $700,000. That equity consists of share capital of $520,000 and retained earnings of $180,000.
Distributable profits = $180,000, because only accumulated realised profits can be distributed, not paid-in share capital.
The board declares a dividend of $250,000 to its two shareholders.
Unlawful portion = $250,000 - $180,000 = $70,000.
The whole $250,000 may be challenged, but the clearly unlawful excess is $70,000, and the directors could be required to repay that amount. The solvency test fails as well: the company holds only $210,000 of cash, so paying $250,000 would require it to borrow $40,000 simply to fund a distribution to its owners.Case study
Seen in the real world.
Redmoor Fabrications is a fictional metalwork business used here to illustrate what can go wrong. Its two owner-directors had drawn $10,000 each per month for several years, a pattern that had always been comfortably covered by profits and was formalised as dividends at each year end.
In one difficult year a major customer went into administration in October, leaving a $310,000 receivable that was ultimately worthless. The directors continued their drawings, and by the year end $240,000 had been taken against distributable profits of only $95,000 once the write-off was recognised, leaving an unlawful excess of $145,000.
The company's bank spotted the distribution during a covenant review and treated it as a breach. In this illustrative account the directors agreed to reclassify $145,000 as an interest-bearing loan repayable over three years, which resolved the legal position but created an unexpected personal tax charge on the outstanding balance. Redmoor then moved to quarterly dividend declarations supported by management accounts and a written solvency check.
Watch out
Common mistakes.
- Treating cash in the bank as evidence that a dividend can be paid, when the test is accumulated distributable profits rather than available cash.
- Declaring dividends from the last audited accounts without checking whether trading since then has eroded the reserves.
- Assuming a revaluation surplus or an unrealised gain can be distributed, when only realised profits count towards distributable reserves.
Questions
People also ask.
Who has to repay an unlawful dividend?
Directors who approved it can be personally liable, and shareholders who knew or ought reasonably to have known it was unlawful can be required to return the money.
Can an illegal dividend be corrected?
Yes, common remedies include repayment by the shareholders, reclassifying the amount as a director's loan on commercial terms, or waiving the dividend before it is paid.
Does the company need audited accounts to declare a dividend?
Not usually, but the board must be able to point to reference accounts, commonly recent management accounts, that reasonably show sufficient distributable profits at the time of the declaration.
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