In formal insolvencies one of the issues that comes up regularly is the classification of payments that have been made to directors in the period leading up to the insolvency appointment. Insolvency practitioners have to identify and realise assets. In owner managed businesses payments to the directors, who are also shareholders, are often made informally over the course of a financial year and then dealt with by way of dividend and or overdrawn directors’ loan accounts when final accounts are prepared. My tax colleagues recently set out some considerations on properly accounting and documenting dividends, read here.
In this article we look at a recent court case where getting it wrong resulted in the director having to pay £250k to a liquidator for what they had believed to be “salary”.
- The company had traded profitably for a number of years.
- The sole director and shareholder drew a monthly amount of between £3,000 and £4,500. Part of this was allocated to an annual salary of £6,000. Profits were such that for many years there were distributable reserves for the balance to be classified as dividends.
- Trading became more challenging and profitability started to reduce. The payments to the director did not. As there were insufficient distributable reserves, this meant that at the end of the financial year there was an overdrawn director’s loan account.
- The company entered liquidation and the liquidator asked that the director pay the director’s loan balance of £250k back to the company.
The director claimed that the she was due adequate remuneration for her position in the company. It was argued that £6,000 is an inadequate salary for someone running a business which at one point had 8 employees and over 400 clients. The argument was that the loan balance should be reduced by a counter claim for reasonable remuneration.
What the court said
- A regular monthly payment is not in itself enough proof that the director is entitled to it.
- Any claim for remuneration needs to be proved, like any other claim in a liquidation. This means that they would have to be identified as amounts legally due to the director for services provided.
- The payments could not be argued as salary as no payroll taxes were paid or accounted for.
- There had been no declaration of dividend (even though the distributable reserves would not have allowed the full amount in any event).
What this means
If remuneration is not properly documented there can be large bills for directors in the event of insolvency.