High Court highlights the risks of drawings in lieu of salary

The high court has held that companies cannot write off a directors loan arising from drawings in lieu of salary just before liquidation to minimise a director’s liability on insolvency.

The court rejected arguments that the loan was salary paid in advance of future dividends, and upheld the idea that where companies do not have sufficient profits, but in any event choose to pay dividends, owner-directors will be liable to repay them on liquidation.

What was the case about (in headline summary)?

Ms Buchanan was the sole director of Bronia Buchanan Associates Limited (the Company). She received a minimal PAYE salary, but she received significantly larger payments in the form of drawings in lieu of salary (resulting in a directors loan showing in the company accounts). The Company ceased trading on 22 September 2014 and entered into insolvent liquidation. In the lead up to liquidation the Company reclassified the ‘directors loans’ showing in its accounts as drawings

The liquidators called upon Ms Buchanan to repay her directors loan, explaining that the reclassification of the loan to Ms Buchanan as “drawings” in the company’s accounts was ineffective to release her from liability to repay it. Ms Buchanan argued that the drawings received should have been recorded as salary, and as such she was entitled to the money drawn, and stated that her professional advisers had informed her that ‘financially matters were fine’. She argued that the loan had been reclassified as drawings the months before liquidation (on the alleged advice of insolvency practitioners) and therefore she was not liable to repay it.

The court rejected Ms Buchanan’s arguments. It decided that, despite her insistence that the amount owed was always payable to her as “drawings,” the sum remained as a debt owed to the Company by her. It therefore fell to be repaid upon liquidation. The attempt of a company, in the final days of its life to write-off a large debt to a connected person was found not to have any effect in law. Had this had been allowed by the court, every owner-director may attempt it in their companies’ final days.

Practical Takeaways

This decision reinforces the position that once a shareholder director elects to be remunerated via drawings in lieu of salary, the drawings payments made to them cannot later be reclassification as having been salary on a ‘quantum meruit’ if there are in sufficient profits to declare a dividend. If a company does not have sufficient profits to declare a dividend to offset those drawings the director will be liable to repay the sums on insolvency.

While this is often seen as the most tax preferable way for a shareholder director to remunerate themselves, it comes with risks. Directors need to balance those risks against the benefits. This analysis will be brought into sharp focus as we exit the COVID-19 pandemic and the restrictions on the ability of creditors to take action against companies are lifted.

Shareholder directors should always take competent professional advice and consider the full implications before remunerating themselves vis this method.