Can a Corporation Pay a Dividend When Retained Earnings Are Negative?

An insightful take on the reasons why having cash on hand is not always a good basis for declaring a dividend and doing so may not even be legally and/or financially sound.

One of the most frequent questions asked by owner-managers of a corporation is: “I have some cash in the bank – am I allowed to declare a dividend to myself?” The immediate response is often positive. However, if retained earnings of the corporation are negative, the issue becomes far more complicated, and the wrong approach may lead to serious legal and financial risks for directors.

The short answer is: it is the corporate statute which determines the ability to declare a dividend, whereas negative retained earnings should be seen as a sign of caution rather than an insurmountable barrier, which makes the salary the more sensible choice.

Understanding Negative Retained Earnings

Retained earnings constitute the accumulated profits of the corporation which have not yet been distributed among shareholders. Negative retained earnings, otherwise referred to as accumulated deficit, simply imply that the corporation’s losses outweigh its gains throughout the history of the business.

And this is where the misunderstanding arises. Accounting profits and cash are not the same things. A corporation may enjoy substantial cash flow even with negative retained earnings since the money can be obtained through borrowing or asset liquidation and collections from accounts receivable.

Salary Versus Dividend

The two are different concepts in every respect. While the salary stands for compensation for rendered services, the dividend represents a return on investment paid to the shareholders as a compensation for their status as investors.

A dividend is supposed to serve as a distribution of the corporation’s profits or of the amounts which the governing corporate legislation allows to distribute.

The difference is critical especially in case of negative retained earnings. Since the payment of a dividend by a corporation with accumulated losses implies a distribution of something which cannot possibly exist, the directors need to make sure the payment does not conflict with corporate legislation and the corporation complies with statutory solvency requirements.

Remember About the Creditors

The decision on declaring a dividend is usually made by the corporation’s management with regard to its shareholders. However, corporate legislation exists to protect the creditors’ interests as well.

When a corporation uses borrowed or extended funds, the corporation owes them to its suppliers, lenders, landlords, employees and tax authorities. Therefore, the creditors assume that the corporation maintains the necessary assets in order to be able to cover its liabilities. The payment of dividends to shareholders while the corporation does not have enough assets leads to a loss of creditors.

This is the main reason why most corporate laws provide the solvency tests. According to the majority of such tests, the corporation is not permitted to pay a dividend if it would be unable to cover its liabilities when they become payable or the payment would lead to the reduction of realizable value of assets below the sum of liabilities and capital stock.

Therefore, before deciding on declaring a dividend, the directors have to review the corporation’s financial statements, its cash flow forecast, contingent liabilities and overall financial health instead of just looking at its bank account.

Why Salary Should Be Chosen

In case of an owner-managed corporation where the owner-manager renders services to the corporation, the salary is often a safer way to go. First, it provides compensation for the services which were indeed rendered rather than the distribution of investment returns which do not exist legally yet. Second, salary reduces the corporation’s taxable income and provides the individual with earned income provided the amount is commercial and properly documented, what is always desirable.

Dividend as a Caution Signal, Not a Barrier

None of this means that a corporation with negative retained earnings cannot declare a dividend. Whether it is possible depends on the corporate legislation of the state where the corporation operates, the corporation’s solvency, balance sheet and particular facts of the situation. That is why the professional advice should be obtained before any distributions in case there is accumulated deficit. There is no reason to make the decision based on the gut feeling.

Conclusion

Negative retained earnings should be considered as a warning signal, not as an absolute prohibition. Cash in the bank does not justify a dividend. Directors owe fiduciary duties to the corporation and have to consider interests of creditors along with interests of the shareholders. If the owner-manager is engaged in the business of the corporation, salary is usually the lower-risk option.

Before declaring a dividend, review the corporation’s legal duties, financial situation and goals. This is the way to have a dividend which is both legal and sound.