Payroll is due on Friday, VAT arrears are piling up, and the supplier who keeps the production line running says everything stops unless they are paid today. When cash is tight, directors face a difficult balancing act: keeping the business operating while protecting creditors and avoiding personal risk.

UK insolvency law does not impose a simple “pay HMRC first” rule during ordinary trading. However, once insolvency is likely, directors must act in the interests of creditors as a whole, and certain debts rank ahead of others if the company later enters administration or liquidation.

This guide explains how that ranking works, how it affects real-world payment decisions, and how to reduce legal risk when funds are short.

The Quick Answer: Who Should Be Paid First?

There is no statutory rule forcing directors to pay HMRC before suppliers during normal trading. However, when insolvency becomes likely, directors must make decisions that minimise losses to creditors overall.

In a formal insolvency (administration or liquidation), the statutory order of distribution generally works as follows:

Rank	Creditor class	Typical debts covered
1	Fixed charge holders	Loans secured on specific assets
2	Insolvency expenses	Office-holder fees and trading costs
3	Ordinary preferential creditors	Certain employee wages and holiday pay
4	Secondary preferential creditors	Certain HMRC taxes (VAT, PAYE, employee NICs, CIS deductions, student loan repayments)
5	Prescribed part	Ring-fenced portion of floating-charge assets for unsecured creditors
6	Floating charge holders	Bank lending secured on circulating assets
7	Unsecured creditors	Trade suppliers, landlords, Corporation Tax, employer NICs

This order is used when an insolvency practitioner distributes assets, not as a mandatory payment sequence for directors before insolvency.

However, it is still highly relevant. If insolvency follows, earlier payments can be scrutinised and, in some circumstances, challenged.

Why Payment Decisions Matter for Directors

When a company is approaching insolvency, directors’ legal duties change. Instead of focusing on shareholder interests, directors must prioritise the interests of creditors as a whole.

Making payment decisions that unfairly benefit one creditor can expose directors to legal risk if the company later enters administration or liquidation.

Wrongful vs Fraudulent Trading

Wrongful trading (Insolvency Act 1986 s214) – Directors may be personally liable if they continued trading when they knew or ought to have concluded there was no reasonable prospect of avoiding insolvent liquidation or administration, and they failed to take every step to minimise creditor losses.

Fraudulent trading (s213) – This involves carrying on business with intent to defraud creditors or for a fraudulent purpose. It requires a high evidential threshold and may lead to civil liability and criminal sanctions.

In practice, documenting decisions, seeking professional advice, and treating creditors fairly are key safeguards.

When Payments Can Be Challenged Later

Payments made before insolvency are not automatically invalid. However, certain transactions can be challenged by a liquidator or administrator.

Preference transactions

Under section 239 of the Insolvency Act 1986, a payment may be challenged if:

• it puts one creditor in a better position than others in the same class, and
• the company was influenced by a desire to prefer that creditor.

Look-back periods:

• 6 months before insolvency for unconnected creditors
• 2 years for connected parties (such as directors or related companies)

If the court finds a preference, it may order restoration of the position, which can include repayment of the money.

Not every payment to a creditor is a preference. For example, payments made for genuine commercial reasons or to obtain new supply may not meet the legal test.

HMRC’s Preferential Status Explained

From 1 December 2020, the Finance Act 2020 restored HMRC’s status as a secondary preferential creditor for certain taxes.

These include taxes collected by businesses on behalf of others:

• VAT
• PAYE income tax
• Employee National Insurance contributions
• Construction Industry Scheme deductions
• Student loan repayments deducted from wages

These debts rank ahead of floating charge lenders and unsecured creditors in a formal insolvency.

However, not all tax debts are preferential.

Taxes that remain unsecured

The following usually rank alongside ordinary creditors:

• Corporation Tax
• Employer NICs
• Penalties and interest

This distinction becomes important if a company later enters liquidation, but it does not create a mandatory payment sequence during trading.

When Suppliers May Need Paying First

In practice, directors often need to balance legal considerations with operational survival.

Paying a supplier before HMRC may sometimes be commercially justified if it protects the value of the business or prevents greater losses to creditors overall.

Examples include:

Retention of Title goods

If goods supplied remain legally owned by the supplier under a Retention of Title clause, failing to pay could mean losing stock that the business relies on to trade.

Critical supply chains

A key supplier may control materials, components, or services necessary to keep the business running. Losing that supply could reduce the company’s value and worsen outcomes for all creditors.

The key principle is acting to minimise overall creditor losses, not automatically favouring one creditor over another.

Test Whether Your Company Is Insolvent

Before prioritising payments, directors should assess whether the company may already be insolvent.

Two statutory tests apply.

Cash-flow test

A company may be insolvent if it cannot pay debts as they fall due.

Indicators include:

• missed payroll or tax deadlines
• creditors demanding immediate payment
• repeated extensions or refinancing to pay routine bills

Balance-sheet test

A company may also be insolvent if its liabilities exceed its assets, including contingent liabilities.

If either test is met, directors must take particular care that decisions prioritise creditors.

A Practical Framework for Prioritising Payments

When cash is tight, a structured approach helps reduce risk.

1. Map all outstanding debts – Identify taxes, suppliers, employees, lenders and their due dates.
2. Assess solvency – Apply the cash-flow and balance-sheet tests.
3. Consider operational impact – Which payments keep the business trading and preserve value?
4. Avoid unfair treatment of similar creditors – Treat creditors in the same class consistently where possible.
5. Engage early with HMRC and suppliers – Many creditors prefer structured payment arrangements to insolvency.
   Document decisions – Board minutes explaining the reasoning behind payments can be critical if decisions are later reviewed.
   

Safe Negotiation Routes with HMRC and Suppliers

Open communication often provides breathing space.

HMRC Time to Pay (TTP)

HMRC may allow businesses to spread tax arrears through a Time to Pay arrangement.

Key points:

• businesses must normally be up to date with tax returns
• HMRC will review the company’s financial position
• arrangements typically last a few months, though longer terms may be possible

TTP allows the full tax debt to be repaid over time, usually with interest.

Negotiating with suppliers

Suppliers may accept:

• staged repayment plans
• reduced short-term payments
• revised credit terms

Providing clear financial information and a credible recovery plan increases the chances of agreement.

Example Scenario: Two Different Approaches

Consider two companies facing similar pressure.

Company A pays a single supplier in full to secure ongoing deliveries while ignoring tax arrears and other creditors.

Company B negotiates with both HMRC and suppliers, spreading payments across creditors while documenting its decisions and attempting to preserve the business.

If both companies later fail, the office-holder may review earlier payments. In Company A’s case, the payment to the supplier might be examined as a potential preference. Company B’s documented approach may demonstrate efforts to treat creditors fairly and minimise losses.

The outcome depends on the specific facts and evidence, not simply which creditor was paid first.

Common Missteps Directors Should Avoid

• Ignoring early warning signs of insolvency
• Paying connected parties ahead of other creditors
• Treating the loudest creditor as the most important
• Failing to keep board records explaining payment decisions
• Continuing to trade without realistic prospects of recovery

Careful documentation and professional advice are often the best protection.

Boardroom Checklist: Before the Next Payment Run

• Review current bank balances and upcoming liabilities
• Update short-term cash-flow forecasts
• Identify taxes owed and whether a Time to Pay request is needed
• Assess operational risks if key suppliers are not paid
• Record the board’s solvency assessment
• Ensure payments treat creditors fairly where possible
• Seek professional advice if insolvency appears likely

FAQs

Your Next Step if Cash Is Too Tight

If you are juggling tax arrears, supplier pressure, and shrinking cash reserves, the most sensible step is to seek professional advice early.

A licensed insolvency practitioner can assess the company’s financial position, explain restructuring options, and help you understand your legal duties. Early advice often improves the chances of preserving the business or achieving an orderly outcome that protects directors and creditors alike.