9 December 2015: In owner-managed companies, it is common for directors to pay themselves a modest salary (usually equivalent to the Personal Allowance) and to receive the balance of their remuneration package by way of dividends. This is often the most tax efficient way to manage the directors' remuneration. However, this can cause directors problems if the company subsequently experiences financial difficulties.
The accounting treatment of dividends is usually for the funds (in excess of the modest salary) received by a director to create an overdrawn director's loan account in the company's records which is then cleared by an equivalent dividend being declared at the company's year end. Whilst this is not necessarily the correct procedure for dividends, as the funds have been received prior to the dividend being declared, it is very common practice. However, it is for this very reason that a director can encounter a problem should the company then struggle financially or enter an insolvency process such as liquidation.
For a company to declare a dividend, it must have sufficient distributable reserves to do so, otherwise, if a dividend is declared (either at year end or part of the way through a year), it is an illegal dividend. Should the company subsequently enter liquidation, for example, it is highly likely that the liquidator would look to reverse that transaction on the basis that it ought not to have been made in the first place and for the benefit of creditors. If a company does not have the ability to declare a dividend, possibly because it has to enter liquidation, the proposed liquidator would attempt to quickly identify if any overdrawn directors' loan accounts exist and discuss these loans with the relevant directors prior to liquidation. These loans would be an asset of the company which the liquidator would look to realise as it is a debt owed to the company, in the same way as if a trade debtor had an outstanding account with the company. A director is often not necessarily aware of this and will have to account to the liquidator for any funds owed to the company.
So what should directors do to protect themselves and the company? The most essential thing for a director to do is ensure that books and accounting records are always up to date and full records are kept of any transactions with the company as, if the director has contributed to the company financially (for example, they may have bought stock personally, lent money to pay wages etc), this can reduce an overdrawn loan account, meaning that a director's exposure is limited. The director should also properly consider at the outset of the company's life and at regular intervals thereafter, whether they should receive remuneration by way of dividends or whether it would be more appropriate to be paid a full salary. This matter is even more prevalent now given April 2016's forthcoming changes to dividend tax rates making them much less of a tax advantage over salary. Therefore, now is the time to consider whether the risk is still worth what will be a slightly lesser reward.
Planning ahead can deal with problems before they arise. That said, it is not always possible to avoid all potential problems and if a director identifies that the company may be about to run into financial difficulties, they should seek immediate professional advice on their position and the position of the company.
At BRI, we are very experienced in advising directors and business owners on their options and so if you, or any of your clients, have any questions relating to directors' remuneration, directors' loan accounts, dividends or any other matter, please do not hesitate to contact any of the BRI Management Team. We are always committed to providing the right advice first time and every time, irrespective of the outcome for ourselves.