Directors' loan vs dividend vs salary: what the liquidator will look at

Salary paid through payroll stays paid. A lawful dividend stays paid. Everything else you took out of the company is a loan, and when the company fails, the liquidator rebuilds that loan from the records and asks you for it back.

The three routes and how they normally work

Most owner-managed companies pay their directors a small salary up to the National Insurance threshold and take the rest as dividends. Anything drawn on account during the year, before a dividend is declared, sits on the directors’ loan account until year end, when the accountant declares a dividend to clear it. While the company is making profits, this is tax-efficient and entirely lawful.

The structure relies on one thing: that the company has distributable profits to pay the dividends. The moment it does not, the year-end tidy-up stops working, and what has been drawn stays as a loan.

What a liquidator does with each

Salary. Paid through PAYE, with tax and NIC deducted and reported in real time, for work done. A liquidator will not touch it. They may look at a sudden increase in the months before insolvency, or a bonus paid while HMRC went unpaid, but ordinary salary is the one route that is never reclassified.

Dividends. A dividend is lawful only if the company had distributable reserves at the time it was declared, shown by the last annual accounts or by interim accounts prepared for the purpose. The liquidator takes each dividend in the last two or three years and tests it against the reserves that existed on that date. Where the reserves were not there, the dividend was unlawful under section 830 of the Companies Act 2006 and is repayable by the shareholder. In an owner-managed company the shareholder is you, you are treated as knowing the position because you signed the accounts, and the repayable dividend is added to your loan account.

The loan account. Whatever is left after salary and lawful dividends is a debt you owe the company. The liquidator demands it, and if you cannot pay, pursues it against your personal assets.

How the balance gets rebuilt

This is where directors are caught out. The last filed accounts might show a loan balance of £8,000, which feels manageable. The liquidator then finds that the company had no reserves in the two previous years, so the £35,000 of dividends declared in each of those years were unlawful. Those come back as loans. The £8,000 becomes £78,000, and the demand letter says so.

A rough test you can run yourself: look at the profit and loss reserve on the balance sheet at each year end. If it was negative, or went negative after the dividend, the dividend for that year is at risk.

The things that make it worse

• Dividends declared after the company was insolvent. Even with reserves on paper, a dividend paid when the company could not pay its debts is a preference to yourself over creditors and can be reversed under section 239 of the Insolvency Act 1986.
• Interim dividends with no interim accounts. A dividend declared mid-year on a guess at profits, with nothing to show the reserves existed, is very hard to defend.
• Backdated paperwork. Minutes and vouchers produced after the event to cover drawings are found by liquidators regularly and turn a civil debt into a conduct problem.
• Treating company money as your own. The company paying the mortgage, the school fees and the car without any of it going through payroll or dividends is the pattern that produces the largest loan balances.

What you can still do

If the company is solvent, get the structure right now: real salary through payroll, dividends only when the reserves support them, with interim accounts if you need them mid-year. Drawings in advance of dividends should be modest and cleared quickly.

If the company is in difficulty, stop taking dividends and stop drawing on account. Take salary through payroll if the company can afford it and the work is being done. Get your accountant to reconstruct the loan account on the liquidator’s basis, testing every dividend against reserves, so you know the real number before anyone else does. Then take that number to a licensed insolvency practitioner, because a settlement negotiated before appointment is better than a demand after it.

What to do today

1. Ask your accountant for the profit and loss reserve at each of the last three year ends, before and after the dividend.
2. Stop drawings on account and any further dividends until the position is clear.
3. Make sure your salary is going through payroll, not being journaled against the loan.
4. If any dividend fails the reserves test and the company is struggling, speak to a licensed insolvency practitioner now.