Many business directors choose to draw funds from a company on a weekly basis, sometimes with a minimal salary. They then declare dividends at the year end to set off against these drawings. This can be seen as being tax efficient.
However, the risks of a director drawing funds in this manner can sometimes outweigh the benefits. With many businesses being at greater risk of insolvency during the Covid-19 pandemic, directors may wish to review their current position and future methods of drawings funds from a company.
Are drawings dividends?
Many directors believe that their weekly or monthly drawings are dividends, but this is incorrect in the majority of cases. Proper steps need to be taken for dividends to be valid. These include drafting board minutes, issuing dividend vouchers and producing up-to-date management accounts to show that distributable reserves are available.
It is a common misconception among directors that drawing funds in this way accrues on their loan account balance. Unfortunately, very few understand this until it is pointed out to them by their accountant or insolvency practitioner, by which time it is too late to take action. Here lies the (sometimes costly) issue: what happens if an insolvent event occurs prior to the final dividend?
The impact of drawings on insolvency
If a company becomes insolvent part way through a financial year, an insolvency practitioner will pursue loan accounts as a company asset. This comes as a shock to many directors and fingers are often pointed at the accountants, although ultimately, it is a director’s responsibility. If drawings and subsequent loan accounts have been high, this can cause tension between parties.
The benefits of a director’s salary
In recent months, many directors have changed the way they are paid by their company and are now opting for the salaried option. As the future is uncertain, this can be a safer option as it mitigates the risk and potential exposure. It is also important to remember that, in an insolvent event, directors may be entitled to redundancy pay-outs and other entitlements. These pay-outs can be significant if a proper salary has previously been drawn.
We are also seeing directors considering further interim dividends to ensure that distributable reserves are being used when available and loan accounts kept to a minimum.
Whichever way directors draw funds out of a company, whether drawings, dividends, salary or something else entirely, it is important that all options are considered. Talking to your accountant and reviewing all of the options could avoid any potential uneasy conversations further down the road.