Distribution and payment of profits in s.r.o. and a.s.

Paying out profits from their own business is one of the important goals for business owners. However, before you, as a partner or shareholder, reach into the company's coffers, you should have a good understanding of the rules that Czech law provides for the distribution and payment of profits in capital companies. In the following article, we explain the legal framework of profit distribution under the Commercial Corporations Act, the roles of the general meeting and the managing directors or board of directors, the necessary financial tests before distribution, the differences between s.r.o. and a.s., the risks of invalidity of decisions and best practices from practice. After reading this article, you will be better prepared to disburse earnings safely and in accordance with the law.

Article author: ARROWS (JUDr. Kateřina Müllerová, office@arws.cz, +420 245 007 740)

Legal framework for the distribution and payment of profits

Basic rules of the law: profit distribution is governed mainly by Act No. 90/2012 Coll., on Commercial Corporations (ZOK), which provides a general framework for all capital companies (i.e. limited liability companies and joint stock companies). According to the ZOK, a profit share can be determined solely on the basis of ordinary or extraordinary financial statements approved by the company's highest body (general meeting). In other words, before profit distribution can take place, the financial statements for the period in question must be drawn up and approved by the general meeting (or by the sole shareholder in the case of a one-member company). As a rule, the decision is made on the basis of the annual accounts after the year-end, but exceptionally, profits can also be distributed on the basis of extraordinary accounts during the year (e.g. when a profit advance is scheduled to be paid).

To whom the profit may be paid: Profits can normally only be distributed to the partners or shareholders of a company in proportion to their shareholdings. In the case of a limited liability company, the share of profit is legally determined by the ratio according to the amount of the shares, in the case of a joint stock company by the ratio according to the nominal value of the shares owned by the shareholder. However, the articles of association or articles of association may determine another way - it is possible to agree on deviations, for example, preferred shares with a higher dividend, or that a certain shareholder is entitled to a different share of the profit than the shareholder's contribution (but the principle of equal treatment must be respected). Furthermore, the law allows the articles of association or articles of association to provide that the profits are to be distributed to persons other than the shareholders. In practice, companies pay out part of the profit to, for example, members of the statutory bodies in the form of royalties (bonuses) or to employees as an incentive share - but only if the articles of association allow it and the general meeting approves it. Without such a provision, the payment of profits to "non-partners" would not be possible. Profits are primarily paid out in cash (unless the articles of association or a resolution of the general meeting provides that, for example, a share in kind may be granted).

Time limits: Current legislation also sets time limits within which profits can be decided and paid out. The accounts must be approved by the general meeting no later than 6 months after the end of the relevant financial year (typically June of the following year). On the basis of such approved accounts, the distribution of profits can then be decided no later than the end of the following financial year (i.e. the end of the following year in the case of ordinary accounts). Furthermore, the approved profit share is payable within 3 months of the date on which the general meeting decides on the distribution, unless the company sets a different deadline. The memorandum of association or the resolution of the general meeting itself may therefore specify a longer or shorter maturity, but if it does not do so, the managing director (or the board of directors) has a statutory period of three months to actually pay the amounts approved. Unforgettable novelty: Should the profit fail to be paid out within this period due to failure to meet the statutory conditions (e.g. due to repeatedly failing the insolvency test, see below), the right to a share of the profit expires on the expiry of that period and the unpaid profit remains with the company. This gives companies an incentive not to delay payment indefinitely and to address obstacles to payment in a timely manner.

The role of the general meeting and the statutory body

The general meeting decides on the distribution, but the statutory body decides on the payout: The Corporations Act confers the power to decide on the distribution of profits on the highest corporate body, which in the case of LLCs and JSCs is the general meeting (or the sole shareholder or shareholder in the capacity of the general meeting if the company is owned by one person). It is therefore the general meeting that determines how much profit is distributed, to whom and in what form (whether in cash or otherwise). Subsequently, it is the task of the statutory body of the company - the managing director (in the case of an LLC) or the board of directors or the management board (in the case of a JSC) - to decide on the actual implementation of the distribution and to ensure that the approved shares are paid to the beneficiaries. Simply put: the general meeting instructs "what to pay out and to whom " and the statutory body ensures "that it is actually paid out" .

Responsibilities before and after the decision: the statutory body has the responsibility to prepare the documents for the general meeting - in particular the financial statements and the proposal for the distribution of profits. On the basis of these documents (and any recommendation from the supervisory board of the Inc.), the general meeting decides by resolution to approve the accounts and the distribution of profits. However, this is not the end of the process. The board of directors or the managing directors must verify that the distribution does not violate the legal conditions - in particular to perform the insolvency test- before the actual distribution. If the AGM approves the payout but it turns out that the payout would be in breach of the law (e.g. a deterioration in the financial situation causes the tests not to be met), the directors may not pay out the money. They have what is known as a braking function: they check the legality and can delay the payout until the conditions are met.

Management responsibility: the members of the statutory body must act with due care and diligence and in the best interests of the company. If they paid out profits in breach of the law, they would be negligent and in breach of this duty. The consequence may be that they are personally liable for damage caused to the company or its creditors. For example, paying a dividend despite the threat of insolvency may result in creditors not being paid - the directors then face the consequences (in the extreme case, they may even be sued in insolvency proceedings or penalised for breach of duty). On the other hand, the general meeting as a whole is not liable, but individual shareholders may challenge the invalidity of a resolution of the general meeting if the distribution of profits is approved in violation of the law or the articles of association. The court would probably annul such a resolution as null and void, or it would be considered as if it had not been made at all if it contravened mandatory provisions of the law.

Administrative steps: once the distribution of profits has been approved, the statutory body has the task of paying out the individual shares. In practice, this means, for example, making bank transfers to the accounts of the partners/shareholders (the payment of the profit share is made at the company's expense and risk, usually in cashless form). In the case of joint stock companies, a so-called record date for dividend payments is often set - typically a few days after the general meeting - which determines which persons are entitled to the dividend (e.g. shareholders registered on that date). If the company does not set such a date in its articles of association or in a resolution, it is usually automatically the date of the general meeting. In an LLC, the record date is usually not decided because the shareholders are clear as of the date of the resolution. Managing directors should also ensure that the profits paid out are properly taxed - for individuals, a withholding tax of 15% is payable on the share of profits (dividend) paid by the company. This too is part of the legal obligations on payout, although the tax aspects are beyond the scope of this article.

Tests a company must meet before paying out profits

In order to ensure that the payment of profits does not undermine the financial stability of the company and endanger its creditors, the ZOK provides for several financial tests. These tests determine how much profit (or other own resources) the company can safely distribute. If the tests are not met, no distribution of profits may be made. Here are the various tests that must be performed before a payout can be made:

• The balance sheet test (the distributable profit test): the general meeting must not approve a distribution of more than the company's available profit. In simple terms, the amount to be distributed must not exceed the sum of: (a) the profit for the last financial year ended (net profit for the year), (b) the results of previous years (retained earnings or unreimbursed losses) and (c) other funds that the company is free to dispose of. From this total shall be deducted any mandatory allocations to reserve or other funds under the law or the memorandum of association. This gives the maximum amount that can be distributed. If the general meeting decides to pay out more, the resolution would have no legal effect. In practice, this means that, for example, old unpaid losses must be covered by future profits before the company can start paying dividends; also, capital funds earmarked for the purpose (e.g. a reserve fund if the company is obliged to create one) cannot be used for distributions. Note: The amendment also introduced a rule on development costs to the balance sheet test - if a company has capitalized development costs in its balance sheet assets (e.g., software development expenses recorded as fixed assets), the amount available for distribution is reduced by the unamortized portion of those costs. In other words, a company with a large investment in development cannot pay out all of its accounting profit, but must retain a portion corresponding to undepreciated development costs as a reserve.

• Equity test: The second test is also performed by the general meeting when making decisions. Its aim is to protect the company's capital and maintain a certain financial stability. No distribution of profits can be made if the company's equity falls below the level of the share capital (subscribed) plus legal or contractual reserves. In other words, the book equity after the distribution must not be less than the sum of the registered capital plus the funds that cannot be distributed. Of course, if the distribution of profits would result in negative equity, this is also not permissible. Again, a decision contrary to this rule is ineffective. In practice, therefore, the company must ensure that, even after payment of the declared dividends, it has a sufficient balance of own funds (e.g. capital + reserves + retained earnings from previous years) above the share capital threshold.

• Insolvency test: the third test lies primarily on the shoulders of the statutory body at the time of payment. The company may not pay out a share of profits if this would cause the company to become insolvent. Insolvency under the Insolvency Act means that the company would be unable to pay its outstanding debts after the distribution (insolvency) or that its debts would exceed its assets (over-indebtedness). This insolvency test is critically important: before each payout, the managing directors or the board of directors must assess the company's current financial situation (cash flow, liabilities, receivables) and evaluate whether paying the proposed amount will cause there to be no money to continue operations and debts. This includes, for example, checking whether the company will have sufficient funds to pay all outstanding invoices and loans after the payout. The insolvency test must also be met when an advance payment of profit sharing (called an interim dividend) is made. If insolvency is imminent, the payment must not be made - the statutory body should postpone or cancel it. The law even explicitly provides from 2021 onwards that if the profit is not paid out by the end of the following year precisely because the insolvency test has repeatedly not been met, the entitlement to a share of the profit ceases (such profit remains in the company's retained earnings).

When to carry out the tests? The balance sheet and capital tests are assessed as of the date of the last financial statements (typically 31 December of the previous year) and are already verified by the general meeting when making decisions. In contrast, the insolvency test assesses the current situation at the time of the payout and is carried out by the statutory body just before the payout. However, the statutory bodies must also ensure that the first two tests are correctly carried out - if the general meeting omits something and approves a payout contrary to the tests, the managing directors/board of directors should not carry out the payout.

Who to contact:

What to watch out for when distributing profits

Even a seemingly simple decision to pay out profits can hide many legal pitfalls. As owners and managers, what should you look out for?

• The validity of the resolution of the general meeting: the decision to distribute profits must be taken in accordance with the law and the articles of association. If the general meeting has not been properly convened, does not have a quorum or has taken a decision contrary to the mandatory tests or the articles of association, the resolution may be challenged and declared null and void or ineffective in court. This would call into question the legal entitlement to the profits paid. Therefore, take care to observe all formalities in calling and conducting the general meeting (invitations, majority, notarial minutes where required, etc.). Please note: A decision by the general meeting to pay out profits that contravenes the statutory tests (e.g. approves a higher amount than the balance sheet test allows) has no legal effect - such a decision is viewed as if it did not exist and the payment is unjustified. In practice, the company would have to recover the defective profit paid in this way from the shareholders. The invalidity of the resolution and the consequent clawback is definitely better avoided by a prudent approach.

• Payment in contravention of the law: as already explained, the statutory body may not pay out profits unless the conditions (tests) are met. Should the payment still be made in breach of the law, there are several penalties: (1) as mentioned above, the recipients will have to return the money to the company, as it is unjust enrichment, (2) the managing directors or board members who approved the payout expose themselves to the risk of liability for damages and may be liable for the losses incurred by the company or its creditors, (3) in the extreme case, if the unauthorized payout leads the company into bankruptcy, it may also be a violation of an obligation under the Insolvency Act (e.g. liability for causing insolvency). It is therefore not advisable to take the statutory restrictions lightly - rather double check that everything fits.

• Insolvency situation: pay special attention to the insolvency test. A company may have sufficient profits on the books, but if it has no liquidity (cash) and large payments are due, paying dividends can easily cause insolvency. Don't underestimate the signs of financial trouble - if you know, for example, that customers owe larger sums or that you will have to repay a loan, consider paying out less profit and keeping a reserve instead. Definitely do not pay out profits from credit or other outside sources; dividends should come out of real money earned, not at the expense of the future survival of the company.

• Prohibition against circumvention of rules: the law prohibits companies from giving any gratuitous benefits (gifts, etc.) to shareholders and persons close to them to circumvent restrictions on the payment of profits. For example, it is not legal to "take" money out of the company by having the directors pay themselves or family members an apparent gift in lieu of profits. Such conduct would be illegal. Similarly, a loan to a shareholder in lieu of a dividend may run afoul of the so-called financial assistance rules or the general duty of loyalty. In short, the transparent payment of profit sharing under the law is the only proper way to get profits out of the company to the owners.

• Registration of beneficial owners: another relatively new obligation is to check the registration of the beneficial owners of the company. According to the Beneficial Owners Registration Act , a profit share cannot be paid to a person who is not properly registered as a beneficial owner in the register. This measure is aimed against anonymity of ownership and money laundering. In practice, this means that if your company has a shareholder who is a legal person (or a trust) and that shareholder does not have a registered beneficial owner, he or she cannot be paid a share of the profits until he or she rectifies this. Similarly, if you personally are the beneficial owner of your company, you should be registered, otherwise the company may not pay out profits to you either. It is therefore worth checking that everything is in order on the owners' records before a scheduled payout so that the payout does not have to be delayed.

• Non-payment of profits and minority protection: there may be a situation where the company makes a profit but the general meeting decides not to pay out the profit (to keep it in retained earnings or use it in some other way). Legally, the general meeting has the right to do so if it has serious reasons and it is not an abuse of majority rights to the detriment of minority owners. Typical legitimate reasons are an uncertain economic outlook, the need to reinvest profits in development, covering losses from previous years or, for example, the creation of an employee fund. Minority shareholders who would like to receive a dividend may not agree to it, but if the majority justifies its decision with compelling reasons in favour of the company, the court will not invalidate such a decision. Beware of the opposite situation, however - if the majority repeatedly fails to allow profit to be paid out without reasonable justification, the minority may defend itself in court. The solution is always to carefully record the reasons for the decision not to distribute profits in the minutes of the general meeting. Open communication with investors or shareholders about the reasons for reinvesting profits also helps avoid disputes.

Best practices for safe profit distribution

Finally, here are some practical recommendations from experienced legal counsel to help you minimize the legal risks associated with profit distributions and payouts:

1. Plan ahead: before the end of the financial year , calculate your expected profit and consider how much of it you will be able to pay out. Consult with your accountant about what items will affect the available portion of the profit (e.g. unused losses from previous years, funds, development investments). This will give you a realistic idea of the maximum amount to distribute under the balance sheet test.
2. Keep a reserve: Although you may be tempted to distribute all of the profit, prudence dictates that you keep a portion as a reserve. The business world is uncertain - creating a financial cushion in your company can protect you from future problems. At the same time, it will easily prevent a capital test breach; equity will remain comfortably above the capital level. In addition, it looks good in the eyes of banks and business partners when a company does not pay out all its profits and reinforces its stability.
3. Thorough checking of the tests: before each payout decision, check all the tests carefully. Check current financial statements: retained earnings, funds, equity value. Do a model calculation of what the assets and liabilities will look like after the scheduled payout. If you are not sure yourself, get an expert opinion from a financial adviser or auditor, especially for larger amounts. For the insolvency test, create a simple cash-flow plan for the following months: write down the expected payments and income. Make sure that, even after deducting the planned dividends, there will be enough money left in the account to cover all liabilities.
4. The formal side of the decision: follow the prescribed procedures for convening and deciding the general meeting. Make the resolution on the distribution of profits clear - state the amount to be distributed, the percentage of profit, if any, and specify to whom it belongs (shareholders' shares, royalties, etc.). You can also include the due date in the resolution (unless you want to use the automatic 3 months). Have the minutes of the general meeting signed and kept. In the case of a.s., ensure that a notarial deed is recorded if required by law (notarial deed is mandatory e.g. for a resolution to change the articles of association or share capital, but not typically for dividends, but it is good practice for clear evidence of the decision). Documentation is crucial for any later checks or disputes.
5. Communicate with owners: if the company has more than one owner, communicate openly with the shareholders about the intention to pay or not to pay out profits. This will prevent conflicts. For example, explain to smaller shareholders why you propose to keep some of the profits in the company (development, investment) - this will increase their trust and reduce the risk of them challenging the decision. Conversely, if you are going to pay a high dividend, let managers and creditors know so they are not caught off guard by capital outflows.
6. Beware of advances: If you decide to advance profits during the year, strictly comply with the legal requirements. Have your interim accounts prepared and actually check from them that you have sufficient profit to pay the advance. Remember that if you have to repay part of the advance later (if the annual profit is less than the advance paid), this may be administratively and financially inconvenient. Therefore, pay advances conservatively - rather less so that you don't have to pay them back later.
7. Consult a lawyer when unclear: Every company has some specifics - whether in the wording of the articles of association or in the financial situation. Do not hesitate to seek legal advice if you are not sure whether you are doing the right thing. An experienced attorney specializing in corporate law can help you review resolutions, interpret bylaws, or identify risks that you might not have thought of (such as restrictions in loan agreements regarding the payment of profits). In these cases, prevention is a cheaper and surer route than litigation or remediation after the fact.

Conclusion: Don't underestimate the legal side of profit disbursement

The distribution and payment of profits in limited liability companies is a key moment in the life of the company, when the owners take the reward for their entrepreneurial efforts. To ensure that this reward is not associated with legal complications, it pays to follow the rules and procedures described here. As an entrepreneur, you will appreciate the opportunity to avoid invalid decisions, penalties or even threats to your company's stability. Remember: the statutory regulation of profit disbursement protects not only creditors and the company, but also you - helping to ensure that you take profits from your business in a sustainable and fair manner.

If you have any doubts about the payment of profits or if you need advice on a specific situation (e.g. setting the terms of a memorandum of association, payment of profits in a group, etc.), please do not hesitate to contact us. We are ready to provide you with a legal consultation tailored to your needs and ensure that the payment of profits in your company is smooth, safe and in compliance with all regulations. Contact us today and avoid the risks - so you can enjoy the profits from your business with peace of mind.