What it means
Companies are legally restricted in how they can return money to their owners. Dividends must strictly come from accumulated, realised profits rather than borrowed funds or capital.
When directors distribute funds without checking the actual financial position, they create an unlawful dividend. This often occurs due to poor bookkeeping, outdated management accounts, or a simple failure to understand statutory accounting rules.
Why does this matter? If a company becomes insolvent, liquidators and creditors will examine past payments.
Directors who approved unlawful payouts can be held personally liable to repay the money back into the business. This means your personal savings and assets could be at risk to cover company debts if you authorized dividends without verifying that sufficient profits existed.
In practice, preventing this issue requires regular, up-to-date financial reporting before any distribution is declared. Accountants must prepare formal balance sheets confirming that distributable reserves are adequate.
If a mistake is discovered early, directors can sometimes pass a resolution to correct the situation or have shareholders formally repay the funds before any insolvency crisis arises. Imagine baking a cake and promising slices to your friends.
If you cut up the actual mixing bowl along with the cake, you are giving away the essential tools needed to bake next time. An unlawful dividend is like giving away parts of the business foundation rather than the actual profit slice.
In practice
Real-world examples
Example 1
TechStart Ltd declares a $10,000 dividend based on the cash in its bank account, ignoring unpaid tax bills and supplier invoices. Once those liabilities are included, no distributable profits actually exist. If the company later fails, the payment can be challenged.
Example 2
A retail business pays regular monthly dividends to its owner directors without keeping proper accounts. When the year-end accounts show a loss, $45,000 of those dividends turn out to be an illegal distribution. The directors must repay the money and pay accountancy fees to correct the records.
Example 3
A growing logistics firm uses a bank overdraft to fund a special shareholder dividend, treating the borrowed cash as profit. This breaks the distribution rules because borrowing is not profit. The bank also learns of the issue when it reviews the accounts, and tightens the firm's lending terms.
Think of it
Imagine baking a cake and promising slices to your friends. If you cut up the actual mixing bowl along with the cake, you are giving away the essential tools needed to bake next time. An unlawful dividend is like giving away parts of the business foundation rather than the actual profit slice.
Formula
Calculation
Distributable Profits = Accumulated Realised Profits - Accumulated Realised Losses
Example 1:
$50,000 of past profits minus $60,000 of past losses equals -$10,000.
Paying any dividend in this scenario is unlawful because the net result is negative.
Example 2 (a dividend that exceeds profits):
A company has accumulated realised profits of $80,000 and realised losses of $30,000, so distributable profits are 80,000 - 30,000 = $50,000.
The directors pay a dividend of $70,000.
Unlawful portion = 70,000 - 50,000 = $20,000, which may have to be repaid.
The cash balance does not change this result, because the legal test looks at distributable profits, not bank balances.Case study
Seen in the real world
This is a fictional, illustrative scenario. GreenLeaf Landscaping Ltd had a tough trading year, but the directors wanted to maintain morale by paying a Christmas dividend of $20,000 to the two co-founders. They looked at the bank balance, saw $25,000 in cash, and assumed it was fine to proceed. They did not check the profit and loss account, which actually showed a retained loss of $5,000 due to delayed client payments and unexpected equipment repairs. Six months later, a major client went bankrupt, forcing GreenLeaf into administration.
The court-appointed liquidator reviewed the company books and flagged the $20,000 dividend as unlawful because it was paid out of capital rather than profits. The directors were ordered to repay the full $20,000 from their personal bank accounts to help pay off unpaid suppliers. The illustrative co-founders later introduced a simple control. Before any dividend, the accountant now prepares a one-page schedule showing distributable reserves, a forecast of the next three months of cash needs, and the proposed payment, and the board minutes record that it was reviewed. This showed that checking cash is never a substitute for verifying actual distributable profits.
Watch out
Common mistakes
- Confusing the bank account balance with available profits for a dividend.
- Failing to document dividend minutes and paperwork properly.
- Assuming an accountant will automatically catch illegal payouts at year-end.
Questions
People also ask
Can we reverse an unlawful dividend?
Yes, if spotted early, shareholders can formally agree to treat the payment as a director loan that is then repaid to the company.
Are shareholders always personally liable to pay the money back?
If shareholders knew or had reasonable grounds to believe the dividend was unlawful, they must repay it. If they were innocent, liability usually falls on the directors who approved it.
Does profit mean the cash sitting in our bank account?
No. Profit is calculated after accounting for all expenses, taxes, and depreciation, which often differs greatly from your current cash balance.