What happens if I make a dividend withdrawal when cash is tight?

The best way to answer this question is to introduce you to Tom. Like many dedicated entrepreneurs, Tom has built his construction business from the ground up. Over the years, he’s relied heavily on his accountant’s advice to structure his income in the most tax-efficient way. The strategy? A modest salary of £12,500 (to make the most of his personal allowance) and £30,000 in dividends annually.

For a while, this worked perfectly. It was a smart way to save on taxes while keeping funds in the business for future growth. But then, 2024 threw Tom and the business an unexpected curveball.

A change in circumstances

Tom fell seriously ill, forcing him to take time off work. Without his leadership, the business struggled, and profits took a serious hit. Despite this, he continued to withdraw the same salary and £30,000 in dividend, unaware that the company could no longer afford it.

Unlawful Dividends and Tax Consequences

What Tom’s accountant needed to explain was that dividends can only be paid from retained profits. What’s that? It’s the company’s accumulated earnings after tax. But with profits down, there wasn’t enough distributable reserves to cover Tom’s usual £30,000 dividend payments.

In simple terms, Tom was taking money that legally wasn’t available for withdrawal. This led to serious tax and legal issues:

  1. Unlawful Dividends – Paying dividends without sufficient retained profits is illegal. If directors knowingly do this, they can be held personally liable.
  2. HMRC Scrutiny – If HMRC investigates and finds the dividends were unlawful, Tom might have to repay the money to his company.
  3. Extra Tax Bills – If the dividends are reclassified as a director’s loan (money Tom owes the company), he could face a 33.75% tax charge under s.455 of the Corporation Tax Act.

What is a Director’s Loan? And what happens if the account is overdrawn?

Tom withdrew dividends without retained profits, so the excess £30,000 is now treated as a director’s loan. This triggers three major tax consequences:

1. Corporation Tax Charge (£10,125)

If the loan isn’t repaid within nine months of the company’s year-end, HMRC will charge 33.75% tax on the outstanding amount. While this tax can be reclaimed once Tom repays the loan, HMRC refunds can take years to process.

2. Benefit-in-Kind Tax (Up to £1,350)

If Tom’s loan exceeds £10,000 and he doesn’t pay interest at HMRC’s official rate, it’s considered a benefit-in-kind. This means:

  • Tom owes tax on the benefit amount.
  • The company must pay 13.8% Class 1A National Insurance.

3. Reclassifying as Salary or Bonus (Up to £15,000 Extra Tax)

If Tom’s company tries to reclassify the £30,000 as salary or a bonus, it will be subject to:

  • Income Tax (20%, 40%, or 45%, depending on Tom’s total earnings).
  • Employee and Employer National Insurance, increasing overall costs. This could lead to an additional tax bill of £12,000-£15,000, making it an expensive fix.

What’s the answer?

It all sounds a bit gloomy to Tom! But, if he can get the right support from his accountant, he suddenly has several options:

1. Repay the Overdrawn Amount

If Tom still has some of the money, he can return it to the company to correct the issue and remove the tax liability. But unfortunately, he’s already spent it on living expenses and mortgage payments. So…

2. Reclassify as a Director’s Loan and Repay Over Time

If he can’t repay immediately, the overdrawn dividends can be treated as a director’s loan. However:

  • If not repaid within nine months, a 33.75% s.455 tax applies.
  • If he is over £10,000, Tom may owe benefit-in-kind tax unless he pays interest at HMRC’s rate.

3. Declare a Future Bonus or Dividend

If the business recovers, Tom could declare a legal dividend or a bonus to offset the overdrawn amount. However, a bonus would attract PAYE and National Insurance, increasing the tax burden.

4. Adjust Future Withdrawals and Seek Expert Advice

To prevent this from happening again, Tom should:

  • Regularly review the company’s financial health before taking dividends
  • Keep an eye on retained earnings and profit levels
  • Consider income protection insurance in case of illness
  • Work closely with an accountant to ensure tax-efficient withdrawals.

Lessons for Business Owners

Tom’s story serves as an important warning for any business owner who relies on dividends for income. And yes, Tom’s really do exist!

While a salary-plus-dividends approach is often tax-efficient, it requires careful financial monitoring.

Key Takeaways:

✔ Always check company finances before taking dividends

✔ If profits drop, adjust withdrawals accordingly

✔ Understand the risks of unlawful dividends and director’s loans

✔ Plan ahead to avoid unnecessary tax liabilities.

By staying informed and working with his accountant, Tom can avoid future tax headaches and secure a more stable financial future.

If you’re looking for trustworthy, impartial and honest advice regarding your business’ financial plan, get in touch with us today.