In many owner-managed companies, the director’s pay arrangements have evolved rather than been designed.
There is a modest salary through payroll. Dividends are taken when cash allows. Personal expenses sometimes find their way through the business bank account. The accountant sorts out the director’s loan account at the year end.
When the company is profitable, that system can appear to work.
But when cash becomes tight, it can unravel very quickly.
The problem is that salary, dividends, expenses, loan repayments and drawings are not interchangeable. They have different legal and tax consequences… and insolvency can expose mistakes that have been quietly building for years.
“Drawings” don’t really exist in a limited company
A sole trader can take drawings because the individual and the business are legally the same person.
A limited company is very different. Its money belongs to the company.
Money taken by a director must normally be recorded as one of the following:
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salary or bonus;
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dividend;
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repayment of business expenses;
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repayment of money previously lent to the company;
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a loan from the company to the director.
Money taken by a director which isn’t salary, a dividend, an expense reimbursement or repayment of money previously introduced is normally treated as a director’s loan.
Calling a payment “drawings” doesn’t alter what it really is.
Salary
A director can be paid a salary for genuine work performed for the company.
It should be:
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properly authorised;
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recorded through payroll;
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subject to PAYE and National Insurance where applicable;
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commercially reasonable;
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affordable.
Salary is not dependent on the company having distributable profits in the same way as a dividend is.
However, that does not give a director a blank cheque.
If a company cannot pay HMRC, employees or essential suppliers, but substantially increases the director’s salary or pays a large backdated bonus, the payment will be examined closely.
However, a reasonable salary for continuing to run and protect the business will be defensible.
Conversely, using salary to extract the last available cash is something very different.
Dividends
A dividend is a return to a shareholder, not payment for work performed as a director.
A company may only pay dividends from profits legally available for distribution. Cash in the bank is not enough. The Companies Act 2006 requires distributions to be made from accumulated realised profits after deducting accumulated realised losses.
A company may therefore have £50,000 in its bank account but no lawful ability to pay a £50,000 dividend.
The cash might be needed for:
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VAT;
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PAYE;
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Corporation Tax;
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suppliers;
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wages;
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loan repayments;
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customer orders that remain unfinished.
Before declaring or paying a dividend, directors should check current management information rather than relying blindly on accounts prepared many months earlier.
The company should also hold the appropriate directors’ meeting, record the decision and produce dividend documentation.
What if the dividend was unlawful?
Where a shareholder knew, or had reasonable grounds to believe, that a dividend was unlawful, there is every chance they will be required to repay it to the company under section 847 of the Companies Act 2006.
That is particularly relevant in an owner-managed company where the director and shareholder are the same person.
A director cannot say:
“I received the dividend as a shareholder. I didn’t know the company had no profits.”
They were also the person responsible for understanding the company’s financial position.
In a subsequent liquidation, unlawful dividends will therefore be pursued as money due back to the company.
The director’s loan account
A director’s loan account records money and assets moving between the company and the director.
If the account is in credit, the company owes the director money.
If it is overdrawn, the director owes money to the company.
Abd that overdrawn balance is an asset of the company.
It isn’t wiped out because the company enters liquidation. It is is an asset that still belongs to the company and, like any other asset, a liquidator can take action to recover it for the benefit of the creditors, and to meet the costs of the liquidation.
This can come as a nasty shock.
A director may believe they have simply taken their normal monthly drawings. The accounts may show that they owe the company £20,000, £40,000, £80,000 or more.
Can a dividend clear an overdrawn director loan account?
Sometimes, but only if:
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the director is also a shareholder;
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sufficient distributable profits genuinely exist;
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the dividend is properly declared;
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the company’s financial position supports it.
A dividend cannot simply be created after the event to make an awkward loan account disappear.
Once the company is insolvent, attempting to clear the account through a dividend is particularly dangerous.
What if the company owes the director money?
Many directors have put personal savings into their companies.
Where the director’s loan account is in credit, the director is a creditor.
But repayment still needs care.
When a company becomes insolvent, directors must consider creditors’ interests rather than their own interests as shareholders.
Repaying the director while leaving HMRC, suppliers and employees unpaid could be challenged as a preference if the statutory conditions are met. Section 239 of the Insolvency Act 1986 allows an office-holder to seek recovery where a creditor has been placed in a better position than they would otherwise have occupied in the insolvency.
That does not mean every repayment to a director is automatically unlawful.
It means it should not be made casually.
Personal expenses
Directors should also review personal costs paid by the company, including:
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private fuel;
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family travel;
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personal insurance;
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home improvements;
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private subscriptions;
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personal credit card bills.
Unless these are legitimate business expenses or properly taxed benefits, they may increase the amount owed on the director’s loan account.
Small payments add up.
A few hundred pounds each month can become a substantial claim over several years.
What directors should do when cash becomes tight
Stop using the word “drawings”
Record each payment correctly when it is made.
Review the director’s loan account monthly
Don’t wait until the annual accounts are prepared.
Check distributable reserves before every dividend
Use current figures which include recent losses and liabilities.
Keep salary commercially reasonable
Make sure it reflects genuine work and the company’s circumstances.
Stop personal expenditure through the company
Separate business and personal finances immediately.
Don’t repay yourself without advice
Particularly where other creditors are overdue.
Preserve the records
Keep payroll information, dividend minutes, vouchers, expense receipts and loan account ledgers.
Takeaway checklist
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Are all director payments correctly classified?
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Does the company genuinely have distributable profits?
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Are the accounts being relied upon sufficiently current?
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Have recent trading losses reduced the available reserves?
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Is the director’s loan account overdrawn?
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Are personal costs being paid through the company?
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Is the director being repaid while other creditors remain unpaid?
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Could any payment be seen as benefiting the director personally?
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Have the decisions been properly recorded?
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Should payments stop until professional advice is obtained?
Final thought
Directors often say:
“I’ve always taken £4,000 a month from the business.”
That may be true.
But habit does not make a payment lawful.
When cash becomes tight, every pound taken by a director needs a clear label, proper authority and a sensible commercial reason.
Get this wrong and the money you thought was yours may become a claim against you personally.
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