When is an Insolvent Company not an Insolvent Company?

When is an Insolvent Company not an Insolvent Company?

March 24, 2021

Whist this may sound like the opening to an insolvency based joke (yes, such things exist) the answer I am thinking of is: ‘When the company has an asset which the directors are not aware of’.

Surely this is a good thing?

Whilst in most scenarios the idea of an unknown asset or windfall is very welcome in times of financial distress, that is unlikely to be the case where a director/shareholder is caught by the ‘dividend trap’.

How does the ‘dividend trap’ arise?

It is common practice in owner-managed businesses for director/shareholders to be remunerated by way of a small salary being paid (often up to individual PAYE allowances) with the remainder being as shareholder dividends. This is because dividends ordinarily attract a lower rate of tax (both for the individual and the company) than would be payable as an employee, therefore it is a win-win.

Practically speaking, since most individuals’ finances operate in a monthly cycle in line with mortgage and other household payments, a director/shareholder will normally draw a fixed monthly sum with (often) little regard to what is deemed as salary or a dividend.

When trading is going well, this is not a problem.  It is common practice for dividends to be declared on an annual basis to account for the payments made to the director retrospectively as salary or dividend, as appropriate.

What is the problem then?

The problem is that unless a dividend is declared before or at the time a payment is made, any monies drawn by the director in excess of their salary will (in the absence of any other reason for payment) represent a loan being advanced by the company to them.  As such, the proportion paid above their salary is owed back to the company from the point it is drawn and repayable on demand.

This is not a problem if trading is profitable since a dividend can be declared in order to cancel the loan out.

The problem arises if trading has not been profitable or (worse) if a cessation event occurs before the annual cycle of drawing and dividend/repayment is complete.

What if losses are being made?

In order for a dividend to be declared, there must be distributable profits available to do so.  As such, if a company has been loss making, it may find that it does not have enough profits to declare a dividend sufficient to repay the amounts drawn throughout the period.

If this is the case, any sums drawn above the amount which can declared as a dividend will remain repayable as a loan owed to the company by the director/shareholder personally.

What if the company enters an insolvency process?

An appointed liquidator or administrator (office-holder) has a duty to collect and realise the assets of the company, which includes any debts owed to it.  In simple terms, if the appointment takes place when there have been amounts drawn in excess of salary without dividends having been declared, the office-holder would have a duty to try and recover the amounts due to the company from the directors/shareholders personally.  No shareholder dividends can be declared once a company is in an insolvency process.

Clearly this position can have serious consequences on the personal circumstances of the individuals involved.

Am I safe if I have already declared a dividend?

This will depend on the documentation relied upon when dividends have been declared.  Whether a distribution can be declared is a decision to be based on ‘relevant accounts’.  For most owner-managed companies, these will be annual accounts although there are allowances for interim accounts to be used if they meet certain criteria.

Any distributions found to have been declared in excess of distributable profits must be repaid to the company.

As directors should be aware, one of the core duties of an appointed office-holder is to carry out investigations and identifying so called ‘unlawful distributions’ forms a key part of this.  A dividend declared (or other payment made) at a time when the company is insolvent may also be challenged by an office-holder as a transaction at undervalue.

But surely a director is entitled to a reasonable wage?

The answer to this no, a director is not entitled be paid for performing their functions and duties.  A person who is a director can however, also be an employee of the company (and therefore entitled to a salary) with or without a formal contract of employment.

The existence (or otherwise) of an employee relationship is a question of fact based on the relevant circumstances.  Ideally there will be a written contract in place, but this is not always the case.

Hypothetical Scenario

Imagine a contractor company which only has one director/shareholder.  It has historically traded profitability but since the onset of the Covid-19 pandemic, has not won any new work. The company has no assets of value and at the end of the last annual period, all profits were withdrawn as dividends, leaving only a small profit reserve to carry forward.  Like many other companies, it received a bounce back loan of £30,000 but has not generated any other income over the last 12 months.

During the period, the director has continued to draw monies to cover their (not extravagant) living expenses and paid themselves a £12,500 salary to use their PAYE entitlement.  The £30,000 loan has now been exhausted and with no work on the horizon, the director is considering winding up the company.

Taking the above situation at face value, the company has no reserves to declare a dividend and therefore the drawings over the salary (totalling £17,500) would represent a loan owed back to the company. As such, if the company is wound up, the liquidator would be duty bound to seek to recover this sum from the director/shareholder.

Put simply, it rather distorts the position of the bounce back loan not having been personally guaranteed, since most of the balance is in effect, repayable.

What if I cannot repay the loan? 

As all Insolvency Practitioners are fully aware, blood cannot be extracted from a stone however, there is a difference between ‘cannot’ and ‘do not want to’.  For example, if a director/shareholder has savings, or owns a house or other asset of value with equity, these assets could be pursued as avenues for recovery.

However, in certain circumstances, recovery will be impossible, and it may be appropriate for the director/shareholder to consider an insolvency process for themselves.  It is not uncommon for a ‘first meeting’ with a director to veer into a discussion regarding their personal position.

What can I do to protect myself? 

As with so many things, prevention is the best cure.  If you have any concerns about the profitability of your company, you should speak to your accountant and take advice.  If appropriate, your accountant may advise switching from a ‘dividend’ remuneration model to a straightforward salaried one. Whilst this might seem counterintuitive since it may increase the tax being paid by the company, the trade-off is that it can obviate the risk of the director being personally liable for a payment.

The other key is to ensure that decisions (particularly those regarding the declaration of dividends) are properly documented by reference to the appropriate financial figures. In distressed situations, there is a risk that decisions may come under scrutiny from an office-holder (or other third party) in due course.

If you are a director who is not good at recording decisions – now is the time to break that habit!

Is there another way out of this?

The answer is that there may be more options available than you might think.  Firstly, if the only creditor is a bounce back loan, repayments can be deferred over a long period and similarly HM Revenue & Customs is currently offering more generous ‘time to pay terms’ than ever before.  In simple scenarios, repayment of overpaid dividends will only be required to the extent that there is creditor pressure – so if this can be abated, so can the need to repay.

If there is other creditor pressure, it may be unavoidable for the company to enter an insolvency procedure.  Even if that is the case, an office-holder will listen to commercial offers for repayment, and it may be possible for this to be dealt with over a reasonable period by way of instalments if a director/shareholder is not in a position to repay immediately.

The key is to take professional advice at an early stage from your accountant and/or an insolvency practitioner. It is also important to be open and honest when speaking to your advisers.  It is much better for all concerned if matters such as overpaid dividends are identified prior to a formal appointment rather than some time afterwards.

If you have any concerns having read this article, please do not hesitate to contact me for a free, confidential no obligation chat.

If you would like to speak directly to Gareth, he can be contacted at:

Gareth Wilcox

+44 (0) 7808 857 694