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It’s not uncommon for directors of owner managed businesses to draw funds from the company by way of a dividend with either no salary or a very low one. The benefit? You pay less tax and this is a good thing, right? But, what happens when the company starts to struggle and enters into an insolvency event?

Drawings are treated as loans from a Company. In practice, a director may draw a regular amount each month, later declaring a dividend at the year-end or at interim periods.

To declare a legal dividend, there MUST be distributable profits in the Company. Board minutes approving the dividend, dividend counterfoils and interim/annual accounts need to be produced each time a dividend is declared. Without this paperwork, you may be at risk!

 

It is also worth remembering that any general loans exceeding £10,000 (as taken for drawings for example) still require the approval of the shareholders.

Let’s look at a scenario where a company enters into insolvent Liquidation half way through the financial year. The director has been taking regular drawings but has yet to declare a dividend to clear those drawings. In addition, a dividend was declared at the end of the last financial year, but it is noted that there were not sufficient distributable reserves. The appointed Liquidator asks the director to repay the loan account and the illegal dividend.

The director claims that he was acting on the advice of his accountant and he should not be held accountable. This is not an uncommon response, but at the end of the day, a director still has a fiduciary duty to the company and he is still liable.

After taking legal advice, the director comes to an agreement to repay the loan account and the dividend. He can get on with his life and put this all behind him…

…or not! The authorisation of unlawful dividends may also be challenged as a breach of fiduciary duty and lead to potential misfeasance. In addition, if the correct paperwork hasn’t been filed, Her Majesty’s Revenue & Customs may look to treat the payments as salary rather than dividends and require NIC payments.

So what else have the directors missed out on? When a Company enters into Liquidation, the government will pick up the tab (up to statutory limits) for employees’ rights payments, including arrears of wages, holiday pay, notice pay and redundancy pay. So what about the director who has been taking his minimal salary? Well, the government will only pay his entitlements based on a minimum wage. This could be significantly less than what he may have been entitled to if he had been taking a salary rather than dividends.

There are many unforeseen circumstances which can impact on a company’s outcome and the above scenario is quite common. We are not suggesting that all directors should stop taking drawings and dividends, but we would suggest that directors should be made aware of the potential consequences if they find themselves facing an insolvency event.

Jon Mitchell is a Licenced Insolvency Practitioner at Thomas Westcott Business Recovery LLP and highly experienced in business rescue, restructuring and insolvency solutions.