What is an Overdrawn Directors Loan Account?
An Overdrawn Director's Loan Account occurs when a director owes the company money. The cause of such an account is when the company makes profits and the accountants advise on saving tax by paying directors a small salary. Directors then take drawings every month from the reserves of profits in the past and current months.
At the end of each month, quarter or year, the board can vote to pay dividends to the shareholders. This way the drawings are cancelled and the dividends voted through to cover the drawings.
However, if the business starts to perform poorly, directors can end up with severe personal liability problems.
How are overdrawn director's loan accounts treated in the filed accounts?
All accounts filed at Companies House should refer to any overdrawn current accounts as loans to the director concerned. You must try to get any loan paid back or reversed in subsequent periods as HMRC will tax YOU PERSONALLY on a fairly penal rate if you do not.
FACT: If the company has no distributable reserves, it cannot pay dividends. So, if your company's balance sheet starts a year with nil or negative reserves, then if you make no profit, you MUST STOP taking dividends as soon as you are aware of this. The accounting term for this is an "overdrawn directors current account". You should not take drawings that cannot be covered by non-existent dividends as essentially you are taking the company's money out as a loan, AND THEREFORE YOU OWE IT BACK AS A DEBTOR.
What if the directors are loaned money from the company?
The same situation occurs if you take a loan from the company to perhaps pay for something unexpected and you intend to pay it back. Funnily enough, it rarely is!
A director can borrow from his own company provided that it is not in financial difficulty and follows the rules as set out in the Companies Act 2006 and the company's articles of association. The shareholders must approve loans over £10,000, but less than £50,000, and the directors will need to agree to the loan terms such as the term and any interest charged. Taking loans from companies can complicate the tax affairs of the company and the director. It is much better to pay yourselves through PAYE and pay the tax/NIC. If the company cannot afford to pay you GROSS, then it is likely to be insolvent and not viable.
What can be done about the director's loans if the company goes into any form of insolvency?
- Repaying the director's loan as you owe the company.
- Offsetting any loans the directors have made to the company (this is called set-off).
- Taking your full salary but reduce the cash you take out of the business to gradually offset the loan account. So pay yourself £4,000 per month but take £1,000. Remember to pay tax on the £4,000.
- Make High profits in future periods to allow dividends to be paid!
- Use a Company Voluntary Arrangement (CVA) to restructure the company.
- You will still have to repay the loan within six months typically.
What Happens in Liquidation?
The liquidator can demand directors repay their debt to the company for the benefit of the creditors. Legal action can be taken to make directors pay this, which could even lead to personal bankruptcy.
A case study on Overdrawn Directors' Loan Accounts
Mr Jones and Mr Smith set up a limited liability design and marketing company based in London.
Sales built quite quickly to £1.2m, based upon their contacts in the marketing sector. Their accountant told them the company had made £80,000 net profit in year one and this would be taxed for corporation tax purposes at roughly 20%.
The accountant advised them to leave their PAYE salaries at a lower level each month in year two and take dividends from the reserves and future profits. They did this for several years and paid themselves quite well as the company was profitable each year.
Then something happened. The company's biggest debtor went bust owing the company c. £158,000. Silly to let that debtor take as much credit in our view, but their view was 'after all, the company was a well known big name customer, and we never thought it would fail'. It had been good regular business for them, so we understand why it got to be such a big debtor.
The company's failure led to a situation that was not planned for. In 2010, the company had a bad trading year on top of the customer's insolvency, and so had to write the bad debt off. Therefore, the company made a significant loss for the year of £250,000. As a result, the balance sheet became negative, and they saw the first flashes of a cash flow crisis looming. No further dividends could be taken, and the directors now had overdrawn directors' loan accounts to the tune of £50,000 in that accounting year that had to be paid back somehow.
Our advice in this situation would be to set out your objectives, look at the viability of the company and then make a decision to ACT.
Referring back to the case study, if the company entered formal terminal insolvency like administration, receivership, voluntary liquidation or compulsory liquidation, then the insolvency practitioner/liquidator could have demanded that the directors repay the £50,000 to the company for the benefit of creditors.
The critical test of any business in trouble is viability. One bad year and a substantial bad debt did not equate to a bad business - far from it. The company in the case study showed dedicated directors and staff.
In a case like this, we would recommend a CVA would be the best solution. The directors' drawings for the current financial year were treated as being net pay through the PAYE scheme in that year because there were no distributable profits. Therefore dividends could not be paid. The prior year's overdrawn directors' account was repaid to the company in six months (a standard HMRC requirement) by the directors. This, of course, generates a slightly larger PAYE and NIC liability. But using the CVA, the debt would be bound by the process. Along with the reduction in employees and managers (the lost contract meant that they had too many people), the company was forecasting a modest profit at best or just below break-even at worst.
Creditors would benefit as they get a deal paying 55% of their old debt back over five years, and they kept their customer.
The benefits for the company are a downsized business, lower costs, long term survival, no lost contracts. We removed cashflow pressures while keeping the bank happy.
Directors would be able to avoid:
- Personal liability
- Business failure
- Bank personal guarantees being called up
Plus as owners of the company, they would have long term employment and a valuable future business.
So if you or your directors are under real pressure then call us on 08009700539 or email on email@example.com for free, high-quality advice. As the above case shows, we can save your business and help you as directors.
Don't you deserve to save your company and look after your financial situation?
Worried about poor cashflow? How to win new work? How to pay wages on pay day? For expert advice on a range of issues download our free Ultimate Guide For Worried Directors today. Or just call us on 0800 9700539
Please note that the guide was written pre Covid-19 and there are some likely changes to insolvency rules regarding wrongful trading. Please see this page here.