The pattern is so common it barely feels like a decision. A small salary through the payroll, and then whatever the business can spare drawn out each month and treated as a dividend. The accountant tidies it up after the year end. It has worked for years.
Then a year goes badly — a large bad debt, a quiet quarter, a customer that went under — and the accounts arrive showing a loss. The drawings did not stop while that was happening. And the question that follows is not a bookkeeping question. It is whether those payments were dividends at all.
The rule, in one line
A company may only pay a dividend out of profits available for the purpose, which section 830 of the Companies Act 2006 defines as accumulated realised profits less accumulated realised losses. Not this year's profit. Not the bank balance. Accumulated distributable reserves.
That distinction catches owners twice. A company can have money in the bank and no distributable reserves, because the cash is customer deposits, a VAT quarter it has collected on HMRC's behalf, or borrowed. And a company can have a profitable year and still no reserves, because losses carried forward from earlier years have to be absorbed first.
The amount also has to be justified by reference to accounts — the last annual accounts, or properly prepared interim accounts where the annual ones do not support the payment. That is the step almost every owner-managed company skips, and it is the one that makes a dividend defensible.
The bank balance tells you whether you can pay a dividend. The reserves tell you whether you may. They are different questions, and only one of them is the law.
What an unlawful dividend turns into
If a dividend was paid without sufficient reserves it was not a valid distribution, and two consequences follow.
Repayment under section 847. Where a shareholder knew, or had reasonable grounds to believe, that the distribution was unlawful, they are liable to repay it to the company. In a company owned and run by the same two people, that is not a high bar. HMRC's own manuals take the view that a member who is also a director of a private company ought to know the position, and that section 847 will apply in the majority of such cases.
Reclassification as a director's loan. In practice this is what actually happens. The payment is stripped out of dividends and posted to the director's loan account, which means the director now owes the money back to the company — and the company has walked into the section 455 regime.
The tax that arrives
Section 455 is a corporation tax charge on a close company where a loan to a participator is still outstanding nine months and one day after the end of the accounting period. For loans and advances made on or after 6 April 2026 the rate is 35.75%, two percentage points up from 33.75%, having risen automatically with the dividend upper rate following the Autumn Budget 2025.
It is refundable, but only nine months and one day after the end of the accounting period in which the loan is repaid — which for a company with a March year end can mean the cash sits with HMRC for well over a year.
Separately, an overdrawn loan account above £10,000 at any point in the tax year creates a taxable benefit on the director unless interest is charged at HMRC's official rate, 3.75% for 2026/27, and actually paid. That goes on a P11D and carries Class 1A National Insurance for the company on top.
A worked example
Illustrative figures, but this is the ordinary shape of it. A two-director consultancy has £6,000 of distributable reserves brought forward. Through the year to 31 March 2027 the directors draw £4,000 a month between them and call it dividends: £48,000 for the year. The year turns out poorly and the company makes a profit after corporation tax of £11,000.
Reserves available are therefore £6,000 brought forward plus £11,000 earned, so £17,000. Dividends declared were £48,000. The excess of £31,000 was never a dividend.
That £31,000 goes to the directors' loan accounts. It is not repaid by 1 January 2028, nine months and a day after the year end, so the company pays section 455 tax at 35.75% on it: £11,082.50, due with the corporation tax. The company has just found an eleven-thousand-pound liability it never budgeted for, in the year it made £11,000.
Each director is also overdrawn by £15,500, above the £10,000 threshold, so unless interest is charged at 3.75% and paid there is a benefit in kind on each of them and Class 1A National Insurance for the company.
And the £17,000 that was a lawful dividend is still taxable in the normal way. From April 2026 dividend tax runs at 10.75% for basic rate taxpayers and 35.75% at the higher rate, with the additional rate unchanged at 39.35% and the dividend allowance still £500.
The four ways out, in order of cost
Repay it. Cleanest. Put the money back before the nine-month-and-a-day date and no section 455 charge arises. Beware the anti-avoidance rules on repaying and immediately redrawing the same money; the bed-and-breakfasting provisions exist precisely to stop that.
Vote a bonus. The company declares salary or a bonus to clear the overdrawn balance. It is deductible for corporation tax, but it attracts income tax at the director's marginal rate plus both employee and employer National Insurance, and the employer element is what makes it expensive.
Declare a lawful dividend later. If the following year generates real reserves, a properly minuted dividend can clear the loan. It works, but the cash is already out and the tax is deferred rather than avoided — and you are one bad year from the same problem.
Write it off. A company waiving a director's loan does not make the problem vanish: the written-off amount is generally treated as a distribution for income tax purposes and can attract National Insurance as well. It is rarely the cheap answer people assume it is.
How to stop it happening
Three habits, none of them onerous.
Watch a running reserves figure, not a running bank balance. Most bookkeeping software will show retained earnings on demand; the check takes a minute, and it belongs before you draw rather than after.
Minute every dividend on the day you take it. A short board minute and a dividend voucher, dated, stating the amount per share. Backdating a year of minutes the following February is exactly what will not stand up.
And where the last annual accounts do not support what you want to take, prepare interim accounts that do. Interim accounts drawn up before the payment, showing sufficient reserves at that date, are the difference between a dividend that stands and one your accountant has to unpick. Where directors properly substantiated an interim dividend at the time, a later deterioration over the rest of the year does not normally make it repayable.
None of this is exotic. It is a fifteen-minute monthly habit that decides whether the money you took out was income or a debt. Directors' loan account: what it really costs covers the other side of that ledger, and salary and dividends: how directors actually pay themselves covers getting the split right in the first place.
Common questions
How do I know whether my company has enough reserves to pay a dividend?
Look at retained earnings, not the bank. Reserves available for distribution are accumulated realised profits less accumulated realised losses, after corporation tax and after any dividends already declared in the year. Most bookkeeping packages show the figure on the balance sheet as retained earnings, so the check takes a minute. Two traps catch people. Cash in the account is not the same as reserves, because some of it is VAT you have collected, customer deposits or borrowed money. And a profitable year does not create reserves if losses brought forward have not yet been absorbed. Where the last annual accounts do not support the payment, prepare interim accounts before you take it.
Can HMRC really make me pay back a dividend?
The claim to repay comes from the company rather than HMRC, but the practical effect is much the same. Under section 847 of the Companies Act 2006 a shareholder who knew, or had reasonable grounds to believe, that a distribution was unlawful is liable to repay it. In an owner-managed company where the shareholder is also the director approving the accounts, that test is usually met, and HMRC guidance says it expects the section to apply in most such cases. What happens in practice is quieter: the payment is reclassified as a director's loan, and the tax consequences of a loan follow — a section 455 charge on the company and a possible benefit in kind on you.
What is the section 455 charge and when do I pay it?
It is a corporation tax charge on a close company that has lent money to a participator, most often a director-shareholder with an overdrawn loan account. The charge applies to loans outstanding at the accounting period end that are still unpaid nine months and one day afterwards, at 35.75% for advances made on or after 6 April 2026, up from 33.75%. It is payable with the company's corporation tax for that period. The tax is refundable once the loan is repaid, but the refund only arrives nine months and one day after the end of the accounting period in which repayment happened, so the money can sit with HMRC for well over a year.
Is it cheaper to leave the loan outstanding or vote a bonus to clear it?
Compare the real cost of each rather than the headline rates. Leaving it outstanding costs the company 35.75% of the balance in section 455 tax, refundable later, plus a benefit in kind on any balance over £10,000 unless interest is charged at HMRC's official rate of 3.75% for 2026/27 and actually paid. Voting a bonus is permanent: income tax at your marginal rate plus employee and employer National Insurance, and the employer element makes it the dearest route for most people. A lawful dividend in a later year is usually cheapest where the reserves genuinely arrive. Model all three with your accountant before the nine-month deadline, not after it.
