This is a very common problem in insolvency and here is the reason why!!
At some stage, a director of a new business will talk to their accountant and ask ‘what is the most efficient way to pay myself ‘? The reply will often be 'pay a basic salary (up to the NI limit) and the rest by dividends'.
Now for a profitable business with reserves, this is the correct advice, although, with recent changes on dividend tax, the differential is falling. I have also had an interesting conversation with an employment solicitor who suggested that paying the basic salary you are in effect breaking the law because you are paying yourself below the national minimum wage but I will leave that for now.
So why does this become a problem in insolvency? Most directors will continue to pay themselves based on the original advice they were given when the business began. However, when the business begins to fail this is when the problems start.
In simple terms at some point, a company in real financial distress will have no reserves and therefore can no longer pay dividends. Normally when this happens the accountant will come to the year-end accounts and then post these illegal dividends to the directors’ loan account which then, in turn, will end up overdrawn directors’ loan account. This then, in turn, leads to further issues as HMRC want the tax to be paid on the overdrawn directors’ loan account making the position even worse. This then becomes a downward spiral.
If insolvency unfortunately finally happens the director is left with a claim against by the appointed insolvency practitioner (IP) for the following;
· Any overdrawn directors’ loan account. This is simply a debt due to the Company and unless the director can show that he has put in funds to repay this it will be due for repayment.
· A claim for illegal dividends. These will be dividends taken when the Company had no reserves and are therefore illegal.
The director will then be left to negotiate with the IP on the above. Most IP’s will generally agree on a commercial deal based on the directors’ personal circumstances. When directors ask what this means I explain it like this ‘If I have a claim for £10,000 and the director has £1m house with no mortgage don’t be surprised that I will want payment in full. However, if the director has limited assets and income then a deal can be agreed.’ This is on the basis that it is a commercial approach and the best outcome for creditors.
Obviously, the best advice for directors is that when the business is struggling, they should revisit their remuneration strategy and amend accordingly to avoid the above issue.
UPDATE FOR JUNE 2020
A recent change in the funding surrounding the Covid-19 relief has seen thousands of small businesses take advantage of the Bounce Back Loan (BBL) Scheme. While this seems on the surface to be a very attractive option as it offers low-cost, turnover based loans, risk-free in most cases, to small businesses with lower turnover, it does come with warnings attached. Recently the government have issued some stern warnings about the abuse of these loans and made it perfectly clear that they will actively pursue those who do. Most importantly though for directors is that there is a little bit of small print concerning when you can take dividends if you have a BBL. This means that taking a BBL could remove your option to use the dividend payment process. Gavin explains more in the accompanying video.
Despite it having a very favourable rate and extended terms (and let's not forget a government-backed guarantee of payment which means no personal liability directors) it is still a loan and should be entered into very carefully. This is particularly true if you pay yourself dividends or are concerned about insolvency.
All these changes may mean that the answer to the question 'How should I pay myself' may well be different in the coming months. Unless there is an unexpected and rather dramatic change in the law though, dividends and directors loans will still have quite an impact on insolvency.
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