What Is A Director’s Loan Account?
Most small businesses are one person companies or have a small number of employees.
The owners take money out of the business usually on a weekly or monthly basis to live on. The most effective way of doing this, to comply with tax regulations, is to pay the whole salary through PAYE. But millions choose to take their “salary” in a different way to reduce tax costs.
Most directors say to us “my accountant suggested I take say £10,000 a year in PAYE salary and the rest will be paid as dividends on the investment I made in the shares of the company”. This is solid tax advice, but most directors don’t listen carefully to it.
Dividends are usually paid annually, but in the meantime we all have to meet rent, mortgages, living costs and so on. So, the director may take say £3,000 a month (£36,000 a year) on top of the modest £10,000 salary paid through PAYE.
It is vital to remind yourself that this IS NOT A DIVIDEND unless those are voted and approved monthly by the board of directors (which is very unusual). Actually, these amounts are called DRAWINGS. Or simply a loan.
The director's loan account is a record of the DRAWINGS transactions between the director and the company itself, excluding salary and dividends. At the end of each financial year this account needs to be reconciled and paid, or more tax will become due.
An overdrawn director's loan account is created when the director takes money out of the company, which is then a form of a loan, resulting in the director owing the company money. In our example, at the end of the financial year the director will therefore owe this £36,000 to the company.
The company will probably have made a profit and this after-tax profit is then voted and distributed in the form of DIVIDENDS to the shareholders. This is NOT a salary. The director has already borrowed the money OVER 12 MONTHS, so no cash is paid as dividends; instead, the DIVIDENDS CANCEL OUT THE DRAWINGS.
All this is fine, provided the company makes a profit and pays corporation tax before allocating dividends to cancel out the loan. But if the company struggles and is not making a profit and therefore cannot pay dividends to shareholders, then the result is that the director owes £36,000 to the company as a loan called an Overdrawn Director's Loan Account.
Over two years of poor performance this could lead to the director in our example owing £72,000 to the company and the company having to pay tax.
When Do Overdrawn Director's Loan Accounts Occur?
The most common cause of an overdrawn director’s loan account is when, acting on tax advice, the director’s income is derived from a small salary and is topped up by taking dividends, which attract a lower income tax rate. Dividends are paid out of what are called distributable reserves. Normally, directors would take drawings every month, but the problems start when the company stops making profits.
Note: 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, and if you make no profit, you should STOP taking dividends as soon as you become aware. 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.
Points to consider:
If you, the director, loan money to your company, it brings the DLA back to zero or into credit, only if the money is paid into the company bank account.
Money can be borrowed from a company by the director as long as the company is solvent (free of financial difficulty) and, the rules are followed as per the Companies Act 2006 and the company’s articles of association. Shareholders must approve loans between the amounts of £10,000 and £50,000, with directors agreeing to the loan terms.
Do Director's Loans Need To Be Paid Back?
Yes. Of course – the loan must be repaid, as does any other type of loan. The director’s loan must be repaid within 9 months of the end of the accounting period, to avoid tax.
There are implications if the loan is not paid back:
- The company may be charged a corporation tax penalty of 32.5% of the loan amount,
- National Insurance and income tax implications (for loans exceeding £10,000),
Can A Director’s Loan Account Be Written Off?
There are limited cases where it is possible to have a DLA written off:
- If a close company (one with less than 5 participators) writes off a director’s loan – on the case that the director is also a participator. Here, the loan is noted as a distribution of profits. If the loan is not given to a fellow participator then the remaining amount is to be taxed as employment income and shall be included on the borrowing individuals’ tax return
- For legitimate reasons, personal liability from a director’s loan can be reduced i.e., mileage expenses or personal expenses used to purchase assets for the company
- The DLA may be reduced by voting the balance as a dividend or bonus – though this will not work if the company is going into liquidation
Tax Implications And Impact On Filing Accounts?
If the overdrawn directors loan account remains after the period of which it needs to have been repaid, then a penal rate of tax (called Section 455) will be charged at a rate of 32.5%. Note: you may be able to have the payment refunded if the charge is paid on time. But if it is nine months and a day after the company’s year-end and the loan account cannot be repaid then HMRC will charge interest on the loan, which will mount up until the S455 corporation tax or the director’s loan account is repaid. At this point, only the corporation tax can be reclaimed not the interest paid (which is at a rate of 3-4%). Read more about S455 here.
In summary, the director will be taxed on the benefit received.
In the company’s accounts disclosure of the loan to directors is always required. This is usually termed “other debtors” in the accounts. If your DLA becomes overdrawn, then the tax returns filed should reflect the amounts owed and tax must be paid on any amount unable to be repaid prior to the nine months after the end of your accounting period.
What Can Be Done About The Director's Loans If The Company Goes Into Any Form Of Insolvency?
Three quarters (or more!) of UK directors have borrowed money from their company at some point in time, with serious implications arising if the loan cannot be repaid and the company becomes insolvent. Professional advice should be obtained as soon as possible.
Ultimately, if a company goes into a form of insolvency and the loan account is outstanding, the appointed liquidator or CVA supervisor will look to recover the debt for the benefit of the creditors.
In such circumstances, options include:
- Repaying the director's loan in full over time
- Offsetting any loans, the directors have made to the company (this is called set-off)
- Taking your full salary but reducing the cash you take out of the business to gradually offset the loan account. I.e., pay yourself £4,000 per month but take £1,000 - remembering to pay tax on the £4,000.
- Make higher profits in future periods to allow dividends to be paid
It is vital to remember, if your company is insolvent, dividends must not be taken from the company accounts as this will worsen the current overdrawn director’s loan account.
What Happens To The Director's Loan Account In Liquidation?
The liquidator will demand that 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. Your personal means may need to be ascertained by the liquidator to determine if you cannot afford to repay the loan. It is a liquidator’s duty to ensure the loan is repaid.
If you cannot pay back the owed money, then you may be forced into personal bankruptcy. In addition to this, the insolvency practitioner has a duty to investigate your conduct as a director before the insolvency or the lead-up to the company’s liquidation. The result could be disqualification of being a director of any company, for up to 15 years.
Summary: AVOID directors loan accounts.
The safe way to pay yourself as a director/employee is through PAYE; the risky way is to take DRAWINGS and hope the company makes sufficient profit to pay a DIVIDEND that cancels out the loan annually.
The company is not YOU, despite you owning the shares. You are an employee of the company which is a separate legal entity to you and must pay tax on the salary you take if over the tax threshold. Any money you make from DIVIDENDS is also taxable under self-assessment.
If you take money out each month to live, these are called DRAWINGS, which is the company lending you money until you can repay it having received dividends.
Simply put, if the company doesn’t make a profit it cannot pay dividends. Then you owe the company the money you have borrowed.