When a business fails, it will often be because it can’t pay its debts as they fall due. Those it owes money to are called creditors. In this article we discuss which creditors are paid first if the company eventually becomes insolvent and its assets are sold to pay its debts (a liquidation or winding-up).
The order creditors of an insolvent company are paid depends on the class of creditors they belong to. Creditors are ranked depending on the type of debt a company owes them. This rank determines the order in which a creditor will be paid.
By definition an insolvent company does not have sufficient assets to pay in full all of its creditors, and a creditor will only be paid in full if there are enough funds to pay all members of its class of creditors as well as all classes of higher-ranked creditors. For more information, get in touch with one of our insolvency specialists.
In this article we will be covering:
- What is insolvent liquidation?
- Who gets paid first in an insolvent liquidation?
- When is a company insolvent?
- Cash flow insolvent companies
- Balance sheet insolvent companies
- What are the risks for directors of an insolvent company?
- Who is a creditor of an insolvent company?
- Who gets paid first, shareholders or bondholders?
- Is HMRC a preferential creditor in insolvency?
- PAYE and NICs in liquidations
- Are employees secured creditors?
- How we can help?
What is insolvent liquidation?
If a company becomes insolvent, then it may be placed into liquidation or ‘wound-up’.
Liquidation is a procedure by which a specialist insolvency practitioner appointed by the court (the liquidator) collects and sells the assets of an insolvent company. The money generated from these sales is then paid to creditors to discharge the company’s debts to them. Liquidation will normally bring the affairs of a company to an end, and the company is eventually struck off at Companies House.
Who gets paid first in an insolvent liquidation?
In liquidation, creditors are paid according to the rank of their claims. In descending order of priority these are:
- holders of fixed charges and creditors with proprietary interest in assets (first)
- expenses of the insolvent estate (second)
- the insolvency practitioner’s fees (third)
- preferential creditors such as employees (third)
- the ‘prescribed part’ set aside for unsecured creditors from funds owned to holders of floating charges up to a maximum financial cap, depending when the charge was created
- holders of floating charges (fifth)
- unsecured creditors (sixth)
- shareholders (seventh)
When is a company insolvent?
A company is insolvent if its debts and liabilities amount to more than its assets. A company will be considered to be insolvent if:
- the company is cash flow insolvent – so that it cannot pay its debts as and when they fall due
- the company is balance sheet insolvent – liabilities are greater than assets
- a creditor is unpaid for a debt more than £750, or
- a creditor has attempted to enforce a judgement against a company without success
Cash flow insolvent companies
If a company is not able to pay its debts (such as the money it owes to suppliers, HMRC or landlords) as they become due, then it will be considered insolvent.
Balance sheet insolvent companies
A company will be judged to be insolvent under the balance sheet test if a court finds that there is a shortfall in the value of a company’s assets versus its liabilities, including future liabilities.
What are the risks for directors of an insolvent company?
In some situations, a director of an insolvent company can be held personally liable for a company’s debts. In addition, they can be convicted of an offence or disqualified from acting as a director, for example:
- Wrongful trading. If a director knows a company is insolvent and will be unable to recover, but continues to trade, they may become personally liable for wrongful trading and have to contribute to the assets of the company and become disqualified as acting as a director.
- Fraudulent trading. If a company has been involved in fraud, then a director involved may have to contribute to the company’s assets, may be disqualified and face criminal sanctions.
- Personal guarantees. If a director has given a personal guarantee in connection with the company’s business, then this can be called in under an insolvency procedure.
- Breach of duty. If a director has not behaved in the best interests of the company in the opinion of the court, they may have to repay that money or account for any company property they have mishandled.
- A company director can’t become involved with a company with a similar name of an insolvent company for five years following liquidation. If they do, they may face personal liability, imprisonment or a fine.
For more information on this see: Directors duties: what are they on insolvency, and how can a director avoid personal liability for breach?
Who is a creditor of an insolvent company?
A creditor is anyone who a company owes money or to whom the company is under an obligation to pay money in the future. The amount of money owed to a creditor does not have to be known at the date of insolvency.
Who gets paid first, shareholders or bondholders?
Shareholders rank behind bondholders, and will generally be paid last, if at all. It is highly unusual for shareholders to receive anything from an insolvency process. A company may only distribute assets to shareholders if there’s anything left over after all other creditors have been paid in full with interest that has accumulated.
Is HMRC a preferential creditor in insolvency?
Where the relevant date of the insolvency is on or after 1 December 2020, HMRC receives secondary preferential creditor status in respect of certain debts due to it. These debts are VAT and other ‘relevant deductions’, including PAYE and Employee NICs, and student loan deductions. In addition, tax incurred during liquidation may enjoy preferential treatment. Corporation tax on gains created by selling the company’s assets are an expense of the liquidation (second class) and corporation tax on income received during the liquidation period is a ‘necessary disbursement’. These taxes will be paid in priority to other forms of debt.
PAYE and NICs in liquidations
For as long as employment contracts continue and employees are paid, the liquidator must operate PAYE for income tax and employee national insurance contributions (NICs). The company continues to be liable for employer NICs.
Are employees secured creditors?
Employees are not secured creditors, but they are preferential creditors for wages due from work done in the four months before the insolvency date (up to £800 per person).
Contributions to pension schemes and holiday pay are also given preferential status. These preferential claims are paid before unsecured creditors and holders of floating charges.
For more information on creditors and their priority ranking on insolvency see: Corporate insolvency: a guide for creditors’ dealing with a company in financial difficulty.
How we can help?
At Harper James we have a specialist insolvency team with many years’ experience advising companies and directors on all aspects of insolvency matters. If you would like to discuss any of the above issues that may relate to your business or yourself, contact one of our team today to discuss your options.