Start by confirming that the dividend really was unlawful and by how much, then have the shareholders who knew, or ought to have known, repay the excess in cash or by a debit to their loan accounts. While it is outstanding, a close company treats the unlawful part as a loan to the shareholder for tax. Once proper reserves exist, a new lawful dividend can clear that loan, but the original payment cannot be approved or relabelled after the event.

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How do you confirm the dividend was unlawful, and by how much?

Section 830 of the Companies Act 2006 allows a distribution only out of accumulated realised profits less accumulated realised losses. Section 836 requires that to be shown by the relevant accounts, and section 836(4) says that if the accounts requirements are not met, the distribution is treated as contravening Part 23 even if profits did exist. The Insolvency Service’s director information hub sums this up: a dividend is illegal when a company pays out more than its available profits or fails to follow correct procedures.

Before assuming the worst, check what the directors had in front of them when the dividend was paid. HMRC’s CTM15205 says a dividend paid on the basis of correctly prepared interim accounts remains lawful even if the annual accounts prepared later show too little profit. ICAEW’s helpsheet on illegal dividends makes a similar point: where interim dividends were properly substantiated and profitability only deteriorated later in the year, liability to repay would not normally arise.

If the dividend was unsupported, work out the unlawful part. Section 847 applies to a distribution “or part of one”, so only the excess over available profits is caught. Remember that section 840 requires earlier distributions made against the same accounts to be counted. The calculation itself is covered on the distributable reserves page.

Which shareholders have to repay?

Under section 847(2), a member who knew or had reasonable grounds for believing that the distribution contravened Part 23 is liable to repay it, or to pay its value if it was not in cash. HMRC’s CTM15205 says a shareholder who had no knowledge and no reasonable grounds is an innocent recipient and does not have to repay, but that in private companies controlled by director shareholders, section 847 is expected to apply in the majority of cases.

ICAEW’s guide for directors of small companies explains why: shareholders must repay if they knew the facts that made the dividend unlawful, even if they did not appreciate the legal consequence, and where shareholders are also directors, facts known to them in either capacity count. In practice, owner managers should assume they will have to repay. Outside investors who had no involvement may be in a different position.

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How is the repayment actually made?

CTM15205 says repayment can be made in cash or by cheque, or by a suitable entry in the loan account. For most owner managed companies the simplest route is to debit each director shareholder’s loan account with their share of the unlawful amount, which converts the purported dividend into a debt they owe the company. The Insolvency Service’s guidance says that dividends paid without sufficient profits will usually be treated as a director’s loan and must be repaid.

In the books, the original dividend was charged to equity, so the correcting entry credits retained earnings and debits the loan account. If the shareholder cannot repay straight away, the balance stays as a debtor. ICAEW’s helpsheet notes that payments to shareholders without proper support as dividends are treated as loans and shown as a debtor in the balance sheet. How that balance is taxed is covered in the director’s loan account guide.

Writing the debt off is not a shortcut. A release transfers value to the shareholder, which ICAEW’s guide treats as a distribution in substance, so with no reserves it repeats the original problem. GOV.UK guidance also says a director’s loan that is written off or released must have Class 1 National Insurance deducted through payroll and income tax paid through Self Assessment.

What is the tax position while it is outstanding?

CTM15205 explains that where the shareholder knew or had reasonable grounds to believe the dividend was unlawful, it is void for the income tax charge on distributions, the shareholder holds the money as constructive trustee, and it does not form part of their income. For a close company, the amount is treated as a loan under section 455 of the Corporation Tax Act 2010, with relief under section 458 when it is repaid, whether by cash or by an entry in the loan account.

Section 455 tax is charged at the dividend upper rate for the tax year the loan is made; section 8(2) of the Income Tax Act 2007 sets that at 35.75% for 2026 to 2027 onwards. Under section 455(3) the tax is due on the day after the end of nine months from the end of the accounting period. If the shareholder already included the payment as dividend income on a tax return, that return may need correcting, because HMRC’s view is that it was not income.

An innocent recipient keeps the money, and CTM15205 says it is a distribution for tax. If that shareholder chooses to repay anyway, HMRC treats it as a voluntary transfer of their own income that does not change the tax position.

CTM15205 also says whether a dividend is unlawful is a company law question, that it is normally the company or its advisers who first raise the point, and that HMRC officers should not generally seek out such cases, except where the dividend forms part of an avoidance scheme.

Can a new lawful dividend clear the debt?

Yes, once the company has enough distributable profits. Those may come from later trading, shown in interim accounts that enable a reasonable judgment of profits under section 838, or from a reduction of capital; see reduction of share capital. The directors then declare a fresh dividend, at the same rate per share for the whole class, and credit it to the loan accounts. That new dividend is taxable when it is paid, not when the original payment was made. The mechanics are covered in crediting dividends to a director’s loan account.

What cannot be done is to pass a shareholders’ resolution approving the original payment. CTM15205 records that shareholders cannot agree to waive the requirements of the Companies Act, citing Precision Dippings Ltd v Precision Dippings Marketing Ltd.

Illustration only. A company with distributable profits of £12,000 pays dividends of £30,000, split equally between two director shareholders. The lawful part is £12,000, so £18,000 is unlawful, £9,000 each. The company debits £9,000 to each loan account. Six months later, interim accounts show further profits of £20,000. The directors declare a dividend of £18,000, £9,000 each, and credit it to the loan accounts, clearing both balances.

How should it be disclosed in the accounts?

ICAEW’s helpsheet suggests that where a dividend was not supported by relevant accounts and reserves are now in deficit, the directors should make full disclosure in the notes, saying that the dividend was not supported and either that it is liable to be repaid or that it was received unknowingly. Director shareholders cannot claim to have received it unknowingly. The directors should also state that no further distributions will be made until reserves are available.

The helpsheet adds that with full disclosure the auditor will probably not need to qualify the report on that point, but will need to assess whether the debtor is recoverable and may need to consider going concern.

What exposure do the directors have if it is not put right?

The Official Receiver’s technical guidance notes that solvency at the time of the distribution is irrelevant to whether it was unlawful, that ignorance of the law is no defence, and that directors who authorise or fail to stop an unlawful dividend can face a misfeasance claim. The Insolvency Service lists repaying dividends received, personal liability for company losses and disqualification proceedings among the consequences if the company later becomes insolvent. Section 1157 allows the court to relieve an officer who acted honestly and reasonably, but that is a discretionary defence. The detail is on the director liability for unlawful dividends page.

What mistakes make things worse?

  • Backdating minutes or interim accounts. ICAEW warns that backdating documents may amount to fraud.
  • Assuming cash in the bank made it lawful. The test is distributable profits, not cash or solvency.
  • Relying on a ratifying resolution. Shareholders cannot waive the statutory requirements.
  • Leaving the loan accounts untouched. Without the correcting entry, the accounts overstate reserves and the section 455 position is wrong.
  • Paying more dividends before reserves recover. Each further payment adds to the unlawful amount.

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Sources

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.