When is a director an employee?

Whether a director is an employee is an important consideration for tax and employment right purposes, as well as other statutory requirements.

Below we examine the question of employment status for directors in more detail, focusing on the rules used to determine if a director undertaking regular remunerated work for a company is an ‘employee’ within the meaning of the Employment Rights Act (ERA)1996.

 

Can a director be an employee?

 

Directors run limited companies on behalf of their shareholders and are officially classed as office holders. An office holder is a person who’s been appointed to a position by a company or organisation but doesn’t have an employment contract relating to that appointment.

In contrast, an ‘employee’ is defined under section 230 of the ERA as “an individual who has entered into or works under (or, where the employment has ceased, worked under) a contract of employment.” The ERA defines a ‘contract of employment’ as “a contract of service or apprenticeship, whether express or implied, and (if it is express) whether oral or in writing.”

As an office holder, a director does not automatically qualify as an employee. However, the mere fact that someone is a director of a company is no bar to that individual entering into a contract to serve that company. Directors aren’t usually provided with employment contracts, although they may be operating under a service contract. A service contract generally sets out terms which would otherwise be contained in a standard employment contract, along with additional duties relating to the director’s role as an office holder.

This means that a director can be classed as an employee for employment rights purposes, provided they’re employed under a service contract by the company, the terms of which make the director an ‘employee’ under the usual common law criteria.

 

What are the ‘employee’ criteria?

 

A director can be classed as an ‘employee’ if they meet the majority of the criteria which are used to determine if someone who works for a business has employed status. A person who works for a business will probably be classed as an employee if most of the following are true:

 

• They work at the business’s premises or at an address specified by the business
• They’re required to work regularly unless they’re on leave
• They’re required to work a minimum number of hours and expect to be paid for that time
• They’re entitled to paid annual leave and other contractual or statutory benefits
• The company’s disciplinary and grievance procedures apply to them
• Their contract sets out redundancy procedures
• Their contract, or any written statement of terms and conditions, uses terms like ‘employer’ and ‘employee’.

 

However, there’s no single test to be applied as to whether a person is an employee or not. An employment tribunal asked to determine an individual’s employment status will be required to take into account various different factors directly relevant to the facts of the case before it.

 

Does a director’s salary impact employee status?

 

As a matter of law, it’s possible for a person to be both a director and an employee, provided they have a service contract with the same company and meet the necessary criteria for employee status, typically including being remunerated for the work that they do.

However, many director-shareholders will not take a salary, instead choosing to draw dividends from the company. In these cases, the director is less likely to be considered an employee compared to directors who are on the payroll. Equally, a director who tops up a small salary with dividends to reduce their tax liabilities is also less likely to be regarded as an employee than someone in receipt of a salary commensurate with their level of seniority.

That said, in the case of Stack v Ajar-Tec Ltd [2015] EWCA Civ 46, the Court of Appeal found that an unpaid company director and shareholder was an employee, based on an express agreement that the Appellant would undertake work for the company and an implied agreement that he would, at some point, be paid for this, once the company had the resources to make payments. Here, the evidence showed an intention to create an employment relationship, albeit to be fully detailed at some point not yet determined.

Clearly, the nature and extent of any payments received by the director is not always decisive either way. Very often, where the employment tribunal is asked to decide whether or not a director is an employee, a range of other considerations will come into play.

 

Can director majority-shareholders be employees?

 

The question of whether or not a director is an employee becomes even more complicated where they are also the controlling shareholder of the company. This will usually be the case in small private companies, where a director has a majority shareholding.

In the context of employment rights, it’s arguably contrary to both common sense and commercial realities to treat a controlling shareholder as somebody who’s also capable of being an employee. The unease often felt about recognising that controlling shareholders can be employees derives from the logic that, in practice, a person cannot — by the exercise of their votes as majority shareholder — both control the company and be subject to its control.

However, even though being a controlling shareholder may raise doubts as to whether that individual is truly an employee, that fact alone does not resolve those doubts one way or another. As the law stands, the fact that a director owns the majority of a company’s shares does not, of itself, prevent that person being employed pursuant to a contract of service.

The view that majority shareholding does not automatically disqualify a director from employee status has been affirmed in a number of cases, including Nesbitt and Nesbitt v Secretary of State for Trade & Industry [2007] IRLR 847. On its facts, the appellants had entered into contracts of employment with a small company they jointly managed as husband and wife, and between them owned 99.99% of the shares. After the company became insolvent, and having been made redundant by the liquidator, they each applied to the Insolvency Service for a statutory redundancy payment, a right only accorded to employees.

Their claims were rejected by both the Insolvency Service and the Employment Tribunal on the basis that they were not classed as employees within the meaning of the ERA.

In finding for the appellants, the EAT had particular regard to the fact that they both had written contracts of employment equivalent to those issued to other employees. The EAT also had regard to the fact that their relationship with the company had been conducted on a basis entirely consistent with the existence of an employment relationship, and they did not receive directors’ fees or dividends, but instead received all of their remuneration by way of a salary.

 

What is the ‘employee’ test for controlling shareholders?

 

Where a tribunal is asked to give effect to a service contract entered into between the company and a controlling shareholder, the extent of control the individual has over the company will be taken into account, but it will not necessarily deprive a director from having employee status, provided they satisfy all the other criteria for employment.

The question of whether or not a majority shareholder in the employing company (whether or not also a director), can be an ‘employee’ was considered in detail in Clarke v Clarke Construction Initiatives Ltd [2008] ILR 364. Although this case went on to be considered by the Court of Appeal, useful guidance as to whether or not a contract of employment should be given effect was provided by Mr Justice Elias in the EAT.

This can be summarised as follows:

 

• Where there is a contract of employment ostensibly in place, the onus is on the party seeking to deny its effect to satisfy the court that it’s not what it appears to be, especially where the individual has paid tax and national insurance as an employee and thereby earning the right to take advantage of the benefits to be derived from such payments
• The mere fact of majority shareholding, or de facto control over a company, does not in itself prevent a contract of employment or service contract from arising
  The fact that a majority shareholder is an entrepreneur, who has built the company up and will profit from its success, will not militate against a finding that there is a contract in place
• If a person conducts themselves according to the contract, for example, as to stipulated hours and holiday entitlement, that’s a strong indicator towards employment, and vice versa
• The assertion of a genuine contract will be undermined if there’s nothing in writing, where the absence of a written contract will be powerful evidence that the contract was not really intended to regulate the relationship in any way
• The taking of loans from the company or the guaranteeing of its debts are not intrinsically inconsistent with employment, where in many small companies it will be necessary for the controlling shareholder personally to have to give bank guarantees
• Majority shareholding and/or control will always be relevant and may be decisive, but that fact alone should not justify a finding of no employment contract.

 

Can a managing director and sole shareholder be an ‘employee’?

 

Even in circumstances where someone has total control, such as the “one man company”, where an individual is both the managing director and sole shareholder, they can still, in theory, enter into a binding and effective contract of employment with their company.

That said, in the case of a limited company with just one director and owner, there’s generally no advantage to the director being classed as an employee for employment law purposes, because they’re unlikely to enforce any of their employment rights against their own company.

 

How does employee status affect a director’s rights?

 

Directors have very different rights and responsibilities from employees. However, if a director has a service contract which qualifies them for employee status, they may be entitled to a number of employment rights. These include the right to claim unfair dismissal or statutory redundancy, including a state-funded payment if the company becomes insolvent.

The example of statutory redundancy payments paid out through the Insolvency Service provides a useful illustration of the importance of tribunals and courts carefully considering the question of employee status in the context of company directors.

The purpose of the provisions under the ERA dealing with insolvency is to make available state-funded compensation for people employed by those whose businesses have failed financially. These provisions were not put in place to provide compensation to entrepreneurs whose own incorporated business ventures have been unsuccessful.

The question of employment status is therefore often a question of where the balance should be fairly struck in affording or denying a person protection under the ERA, based on the business reality of a director’s employment relationship with the company in question.