Directors' Pay Conundrum - Part 2

In the last issue of our newsletter Tim Southern of Southern Consulting very kindly produced an article on Directors’ Pay which looked at the different options available to directors of owner managed businesses.

Generally directors pay themselves through a mix of a low salary and dividends as this is the most tax advantageous way in which to draw funds from their businesses. This is all well and good as long as the business is performing and makes sufficient net profit, after tax, to have the distributable reserves to meet the dividends that are paid.

A loan by any other name

In my experience what tends to happen with owner managed businesses is that the rising level of drawings reflects the lifestyle expectations of the individual rather than the performance of the company, and in many cases dividends are paid on account before the profits are achieved.

There is a simple assumption that it will all be sorted out at the year-end by the accountant. Indeed over the years I have seen plenty of examples whereby the director simply looks upon the company’s cash resources as his or her own and merrily spends it without thinking about the company’s other obligations.

This is all fine when profits are in line with or ahead of expectation; but when the level falls below that required to meet the amount drawn down the accountant has no other option at year end than to adjust the figures to show the “overdrawn” amount as a loan to the director.

Hard lessons pay dividends

This has tax consequences for the company in that it is liable to pay tax on the balance outstanding until it is repaid. (Details of the specific charges are not the subject of this article and independent advice should be sought if this is an area of concern).

In an on-going situation this would in itself not be a problem if the debt is subsequently repaid, either through future dividends or an injection of funds. However, if the business subsequently fails then the duly appointed Insolvency Practitioner is going to be looking to recover those funds for the benefit of the company’s creditors.

I have a number of cases at the moment where the business has failed and there are overdrawn directors’ loan accounts.

Keep your shirt, and your house

Business failures can be a very stressful time for the director. They see the loss of their income as well as face the possibility of having to deal with guarantee liabilities and more often than not they themselves are facing financial hardship as a result. For the Insolvency Practitioner to then come along and demand repayment of funds withdrawn from the company will only add to the stress and hardship. In a worst case scenario this could lead to a person’s bankruptcy or sale of the family home, as the only asset.

Reality check

Nobody plans to fail but a director can take action to mitigate the risks of having additional financial burdens arising from a business failure:

  • Firstly, know how the business is performing with regular management accounts.
  • Only draw dividends from the business when the profit has been achieved.

I appreciate that in the day-to-day throng of running a business this isn’t always as easy as it might sound and drawings from a business reflect the individual’s requirements. While not the most tax efficient way of dealing with things I tend to think that the simplest arrangement would be to draw a salary that is sufficient to meet the normal requirements for an individual and for dividends to be drawn separately when the profits achieved are known. This would be particularly applicable if the business profits are uncertain or volatile.