In more than 75% of our calls from directors of struggling companies, we find that this is a major problem. So what is an "overdrawn director's loan account?"
What is an Overdrawn Director's Loan Account?
An Overdrawn Director's Loan Account occurs when a director owes the company money. This can happen 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 badly, directors can end up with serious personal liability problems.
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" but it is often referred to as a director's overdrawn loan 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.
Borrowing 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.
Loans in excess of £10,000 but less than £50,000 must be approved by the shareholders and the directors will need to agree 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. Ross Martin Accountants have a very good page on this subject here. We are mainly concerned about overdrawn director's loan accounts in the context of insolvency.
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 is not likely to be viable?
What can be done if the company goes into any form of insolvency?
- Repaying the director's loan as you personally 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.
- Making lots of profits in future periods to allow dividends to be paid!
- Use a company voluntary arrangement (CVA) to restructure the company (see more information on this rescue method further down in this guide).
You will still have to repay the loan within 6 months normally.
What happens in liquidation?
The liquidator can demand directors repay their overdrawn director's loan account 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.
Overdrawn directors loan account case study
Mr Jones and Mr Smith set up a limited liability company based in London. It is a design and marketing company.
Sales built quite quickly based upon their contacts in the marketing sector and the company grew to £1.2m sales. 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 a number of years and paid themselves quite well as the company was profitable each year.
Then something happened. Their 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 clearly 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. This made a huge 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.
So 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 a 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 back to the company for the benefit of creditors.
The key test of any business in trouble is viability. One bad year and a huge bad debt did not equate to a bad business - far from it. The business 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 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 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 5 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 whilst 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 have an overdrawn current account and a company that is under real pressure then call us on 08009700539. 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 own personal financial situation?
Author: Keith Steven
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Categories: Implications for Directors