What If I Pay Staff but Not HMRC Before Liquidation?

Facing liquidation, you might struggle with whether to prioritise staff wages over HMRC debts. While paying employees may feel morally right, it can carry legal risks if not handled carefully. Under UK insolvency law, certain employee claims (such as limited arrears of pay and holiday pay) rank as preferential debts. Since December 1st 2020, HMRC also holds a secondary preferential position for specific taxes that businesses collect on behalf of others, including PAYE and VAT.

Paying one group of creditors shortly before liquidation can, in some circumstances, be challenged by a liquidator. Understanding how creditor priority, preferences, and director duties operate is crucial to navigating insolvency responsibly.

At a Glance

• Paying employees before HMRC shortly before liquidation is not automatically unlawful, but it can be challenged if it meets the legal test for a preference
• Employees are preferential creditors for limited arrears of pay and certain holiday pay, subject to statutory caps
• Since 1 December 2020, HMRC is a secondary preferential creditor for specific taxes collected on behalf of others, including PAYE, employee NICs, VAT, CIS, and student loan deductions
• A payment is only a preference if it puts a creditor in a better position and was influenced by a desire to prefer that creditor
• Liquidators can apply to court to challenge and unwind certain pre-liquidation payments, but recovery depends on the facts and statutory conditions
• Continuing to trade when insolvency is unavoidable may expose directors to wrongful trading liability
• Employees can claim certain unpaid wages, holiday pay, notice pay, and redundancy pay from the Redundancy Payments Service, subject to statutory limits
• Directors may face personal liability or disqualification if they breach their duties during insolvency, but unpaid tax does not automatically transfer to them
• Northern Ireland follows a separate insolvency framework, although creditor priority is broadly similar across the UK
• Early advice from a licensed insolvency practitioner is critical to reducing personal risk and ensuring legal compliance

Why Directors Might Consider Paying Staff Over HMRC

Directors of UK limited companies facing financial distress may feel compelled to prioritise paying their employees over settling debts with HM Revenue & Customs (HMRC). This inclination often stems from a sense of moral duty and practical necessity. Employees rely on their wages for day-to-day living, and ensuring they are paid can help maintain stability during a difficult period.

There can also be a perception that employees, as individuals, are more vulnerable than an institutional creditor such as HMRC. Emotional pressure, fear of workforce fallout, or concern about unpaid wage claims can influence decisions made during financial distress.

However, directors must understand that once a company is insolvent, their duties shift towards protecting the interests of creditors as a whole. While supporting employees is understandable, decisions about payments must be assessed against insolvency law and director duties to avoid unintended legal consequences.

Understanding the Creditor Hierarchy in Insolvency

When a company enters liquidation, creditors are paid in a strict statutory order. This hierarchy determines how realised funds are distributed.

1. Fixed Charge Secured Creditors – Creditors with security over specific assets (such as land or machinery) are paid first from the proceeds of those assets.
2. Insolvency Expenses and Office-Holder Fees – The costs of the insolvency process, including the liquidator’s fees and expenses, are paid next.
3. Preferential Creditors – Employees are preferential creditors for certain claims, including limited arrears of pay (subject to statutory caps and time limits) and certain holiday pay.
4. Secondary Preferential Creditors – HMRC ranks as a secondary preferential creditor for specific taxes collected by the company on behalf of others, including PAYE income tax, employee National Insurance contributions, VAT, CIS deductions, and student loan deductions.
5. Floating Charge Secured Creditors – Creditors with floating charges over general business assets are paid after preferential and secondary preferential claims.
6. Unsecured Creditors – This group includes trade suppliers, lenders without security, and HMRC debts that do not qualify as secondary preferential. They are often paid last and may receive only a small proportion of what they are owed, if anything.

Understanding this order is essential when assessing payment decisions during financial distress.

Legal Implications: Preferences and Wrongful Trading

When a company is insolvent, directors must be mindful of the rules on preferences and wrongful trading.

A preference arises where a company does something that puts a creditor in a better position than they would otherwise have been in insolvency, and where the company was influenced by a desire to prefer that creditor. Simply paying one creditor and not another does not automatically amount to a preference; the statutory test and the surrounding circumstances are critical.

Paying employees shortly before liquidation could be examined by a liquidator, particularly if it appears the payments were made to improve employees’ position relative to other creditors. Whether this constitutes a preference depends on the facts and the statutory criteria.

Wrongful trading occurs where directors continue to trade at a time when they knew, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent liquidation, and they failed to take every step to minimise losses to creditors. This can result in personal financial liability.

Understanding these concepts and seeking advice early is vital to reducing personal risk.

Consequences for Directors: Disqualification and Personal Liability

Directors who fail to comply with their duties during insolvency may face serious consequences. If a liquidator concludes that a director has engaged in misconduct, such as wrongful trading or making unlawful preferences, they may pursue recovery actions or report the conduct to the Insolvency Service.

Under the Company Directors Disqualification Act 1986, directors can be disqualified for between 2 and 15 years if their conduct is found to make them unfit to manage a company. Insolvency-related misconduct can include failing to properly consider creditor interests once insolvency is unavoidable.

While HMRC’s status as a secondary preferential creditor does not give it special enforcement powers over directors by default, failure to manage tax obligations appropriately can still form part of an overall assessment of director conduct.

How Liquidators Challenge Pre-Liquidation Payments

Liquidators have the power to review transactions made before liquidation and, where appropriate, apply to court to unwind them. This includes preferences and transactions at an undervalue.

A preference can generally be challenged if it occurred within the six months before insolvency (or longer in the case of connected persons) and if the statutory conditions are met. Any recovery requires a court order and depends on the specific facts.

If a transaction is successfully challenged, the court can order that the company’s position be restored as if the transaction had not occurred. This may involve recovering money from the recipient or, in some cases, seeking compensation from directors.

Employee Protection Measures During Insolvency

Employees are not left without protection if a company enters liquidation. Certain employee entitlements can be claimed from the National Insurance Fund via the Redundancy Payments Service (RPS).

Eligible claims can include:

• Statutory redundancy pay
• Unpaid wages (subject to weekly and time-based caps)
• Holiday pay accrued in the 12 months before insolvency, up to statutory limits
• Statutory notice pay (subject to deductions and caps)

Any amounts already paid by the employer are deducted from what the RPS pays, preventing double recovery. These statutory schemes provide a safety net rather than full compensation.

Practical Steps and Next Actions for Directors

When insolvency becomes likely, directors should act carefully and promptly:

• Seek professional advice early from a licensed insolvency practitioner.
• Keep accurate financial records to demonstrate transparency and good conduct.
• Avoid selective payments without advice, as some may later be challenged.
• Engage with HMRC and other creditors where appropriate, noting that Time to Pay arrangements are only viable for businesses that remain viable.
• Consider ceasing trade if continued trading would increase creditor losses.
• Communicate appropriately with employees, including providing information needed for RPS claims if redundancies occur.

Engaging a Licensed Insolvency Practitioner

A licensed insolvency practitioner can help directors understand their legal duties, assess risks, and navigate available options such as administration or creditors’ voluntary liquidation. Early advice can reduce the likelihood of personal liability and ensure decisions align with insolvency law.

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