Paying yourself through directors' loans and dividends is risky business

Many directors of SMEs are taking huge risks when it comes to paying themselves without realising – and it is often on their accountant’s advice.

It is very common that a company’s accountant will advise directors of owner-managed companies to take the majority of their pay as dividends with either no salary or a very low one. This has a financial advantage, particularly as far as national insurance contributions are concerned. The director then simply draws a monthly sum from the company’s bank account to live on and, at the end of the year, these monthly drawings are declared as a dividend.

The director comes away from such an arrangement feeling pleased that they have saved money from going to the taxman but little do they realise the huge risk they are taking with their family’s livelihood.

The worst case scenario (which unfortunately is becoming all too frequent these days) is that, after the company goes into liquidation or administration, or after the company is sold, a claim is made against the director to pay back up to 6 years’ pay!

From an accounting perspective, the monthly drawings are treated as loans from the company to the director. What many directors don’t realise, however, is that this type of loan to a director is only legal if there is a shareholders’ resolution approving of it coupled with a ‘memorandum’ setting out the nature of the loan, the loan amount, its purpose and the extent of the company’s liability. There is an exception for a loan of not more than £10,000 but, as most directors wouldn’t be satisfied with annual earnings of £10,000, this is unlikely to be helpful.

So the first thing you need is a shareholders’ resolution coupled with a memorandum. Most accountants now realise this and will help you in drafting the paperwork.

But this is only half the problem. There are strict rules as to when dividends can be paid. For example, they can only be paid out of profits and cannot be retrospective. The idea is that you look at your profits and, if sufficient, you can declare a dividend that is then paid out. What you cannot lawfully do is backdate a dividend declaration to try to make a loan payment look like a dividend payment.

Backdating a dividend declaration is fraud and the courts do not like it, so don’t expect any sympathy from that direction.

So what can you do? Well, you should keep it legal and not pay yourself in this way. Often taking remuneration as a salary, or as payment for your services, is the best bet but this must be allowed in the company’s articles.

Alternatively, you can do what most directors in this situation do and hope for the best. After all, you don’t plan to sell the company any time soon, you and your fellow directors get on well and will never fall out with each other, and it won’t be your company that becomes insolvent, will it?

If none of these things happen, it’s unlikely that you’ll be found out. But, then again, if they do, and someone takes a close look at the company paperwork (as a liquidator for example is likely to do), you could find yourself having to pay back up to 6 years’ pay.

If you ever do find yourself at the wrong end of a claim for repayment of remuneration, get in touch, we can help.

Gary Cousins
Business Solicitor