Director’s Loan Accounts and Dividends

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 to pay a basic salary (up to the NI limit) and the rest by dividend. 

For a profitable business with reserves, this is common and correct advice, although, with recent changes to dividend taxation, the differential is falling. However, under the current taxation rules, it is still a very efficient way for a solvent business to pay directors.

The problem comes when the business is no longer solvent. Not only is it a decision that could be a potential problem, but it can also be a financially disastrous one for the directors.

Why do Directors loans and dividends become such a problem in the event of insolvency?

Most directors will continue to pay themselves based on the original advice they were given when they started their business regardless of any changes to circumstances. It’s a very easy trap to fall into. However, if the business begins to fail the problems start.

It stands to reason that when a Company is in real financial distress, it will have no reserves at some point. If it has no reserves then it can no longer pay dividends. Simply put, Directors cannot be paid dividends as there is no money to pay them yet often they continue to do so because that is what they have always done. Normally, when this happens, the accountant will come to the year-end accounts and then post these wrongly taken dividends to the director’s loan account. At this stage, the Director ends up with an overdrawn director’s loan account. This, in turn, leads to further issues as HMRC want the tax to be paid on the overdrawn director’s loan account, making the position even worse. A spiral has started that potentially becomes a financial problem.

If unfortunately, insolvency finally happens, the director is left with a claim against them by the appointed insolvency practitioner (IP) for the following;

•  Any overdrawn director’s loan account.

This is now 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 IPs will generally agree on a commercial deal based on the director’s 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 where an arrangement is made for payment and the best outcome for creditors. Obviously, this will always depend on the individual circumstances.

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 issues.

If you are struggling with potential insolvency, the sooner you take advice the better. We are happy to discuss this with you further and offer a free 20 minute initial call to talk through your problems.