Director pay structures that create tax risks on exit
When a business is getting ready for sale, director remuneration is often an early focus in tax due diligence. Arrangements that have worked perfectly well for founders over the years can look very different under buyer scrutiny, especially where the lines between salary, dividends and shareholder returns are blurred.
Tax problems rarely result from bad intentions. More often, the risk builds gradually: a low salary becomes standard, dividends are paid regularly, paperwork falls behind, and the commercial rationale is assumed rather than recorded. In a transaction, those historic decisions are tested quickly and thoroughly. If the position cannot be explained clearly, buyers may see Pay As You Earn (PAYE) and National Insurance Contribution (NIC) exposure and factor that into price and structure. They may even pull out of the sale.
What director pay structures do buyers often challenge?
Low salary, high dividends
Many owner-managed businesses use the structure of low salary, high dividends legitimately. The risk grows where a director is paid only a modest salary, often around the personal allowance level of £12,570, despite performing a significant executive role. At that point, buyers may ask whether the salary is commercially supportable or whether part of the dividend stream is really reward for work done. If it is, PAYE and NIC should have been applied through payroll.
Dividends instead of salary
It can be hard to defend a situation where directors take no salary and extract value only through dividends, especially if the individuals are deeply involved in running the business, making decisions, managing staff and driving profits. In due diligence, this often surfaces through a straightforward comparison between payroll records and the reality of how the business operates. If a key director is central to trading but absent from payroll, buyers will ask a simple question: is this really a return on share ownership, or untaxed remuneration?
Dividend patterns that look like pay
How dividends are paid matters. Fixed monthly payments, equal amounts throughout the year, or distributions that appear guaranteed regardless of performance can start to look like salary. Buyers will review board minutes and accounting records to see whether payments were genuinely declared as dividends or simply operated like regular pay. If the latter looks more likely, the risk of recharacterisation increases, along with possible PAYE, NIC, interest and penalties.
Inconsistent pay year to year
A salary and dividend mix that changes sharply from year to year without an obvious commercial reason can rouse suspicion. Shifts in profitability, cash flow or business maturity may explain changes in approach. But where the pattern appears driven mainly by tax efficiency, with no clear underlying rationale, buyers are likely to ask more questions. In a deal process, inconsistency often means more document requests, more scrutiny and more caution.
How real is the risk?
Director remuneration is often a grey area in due diligence. Unlike more defined and absolute risk areas, such as directors paid off-payroll, these issues rarely turn on a single technical test. Instead, the risk usually depends on whether HMRC could argue that the commercial reality does not match the legal form, based on the facts, the supporting records, and how clearly the business can explain its approach.
What can reduce the PAYE and NIC exposure for directors?
The headline exposure is not always as severe as it first appears. Directors will usually already have paid tax on dividends, and the rate differential compared with employment income is often relatively modest, although NIC can still be significant. There may also be scope to reduce the net cost through corporation tax relief if payments are reclassified as deductible remuneration.
What should companies do before exit?
The key message is simple: review director remuneration before the sale process starts, not while diligence is under way. A pre-sale health check can highlight salary levels that are hard to commercially justify, dividends that are not fully supported, and gaps in documentation or payroll reporting. Often, the issue is not just the tax cost. It is how the risk looks to a buyer. A business that understands the issue, has quantified it and can explain the history will usually be in a far stronger position than one trying to piece everything together under deal pressure.
If you are planning a sale and want to understand potential risks in your director pay arrangements, please get in touch with Andrew Timpson or your usual contact.