Within the past several years there has been an ever-growing number of company directors who opt to take their salary in the form of dividends as opposed to being paid through the PAYE system. The reason for this is quite clear in that they are not liable for National Insurance Contributions on this ‘income’ and the amount of tax on capital gains is usually lower than income tax on the same amount. Their ultimate goal is to realise greater profits by paying fewer taxes.
Related: A guide to Value Added Tax
Normally this would be a logical choice, but with the number of businesses going bust, a director should be aware of the drawbacks if his/her company should be faced with insolvency. The insolvency practitioners at Real Business Rescue have found that many directors are not aware of the statutory guidelines for paying dividends. If you are a director considering your options, here are a few of the consequences you may encounter when being paid in dividends.
Some dividends are deemed illegal
Unfortunately, the statutory procedures for being paid in dividends are highly complex, and the average director or owner doesn’t have the legal background to understand what constitutes a ‘legal dividend.’ In short, if a company goes bankrupt and any dividends having been paid are found to be illegal, the director will be required to give that money back!
Illegal dividends must be paid back
At this point, the director is at a loss why he or she should be required to give the money back when by rights it should have been their salary. While this is true, it is important to keep in mind that a dividend is not a salary for work performed in the strictest sense but rather a percentage of the profits set aside for the purpose of paying shareholders. By requesting payment through dividends, the director thus becomes a shareholder or member.
Creditors are preferential during insolvency
Once it is understood that a director being remunerated in the form of a dividend becomes a shareholder in the business, it is easy to see how problems can arise. Remember that according to the insolvency statutes in the UK, creditors take front and centre stage when it comes to being paid. All shareholders (members) need to wait until creditors have been satisfied before any leftover monies can be distributed.
Being hit with an overdrawn director’s loan account without having borrowed money!
By this point, it is understandable how some directors are flabbergasted when they are summarily notified by the liquidator or administrator of an insolvent company that they have an overdrawn director’s loan account. Insolvency Practitioners report that they are often contacted because they feel the liquidator/administrator must be mistaken, they never took a loan against the books. Unfortunately, according to UK law, they did! Any illegal dividends paid is to be considered a directors loan and must be repaid from personal finances.
In short, it might sound tantalising to be paid in dividends as opposed to through the normal PAYE scheme, but you should think long and hard before choosing this path. Yes, the immediate benefits of higher pay are enticing but what happens if your company should go bust? Do you know what constitutes a legal dividend? Make sure that you have your facts straight before accepting this form of payment.
Being paid in dividends is only for directors of solvent companies with an experienced accountancy or solicitor. It would be horrid to work months only to have to pay back everything you worked so hard for. After all, no one works for free.