What Is A Director’s Loan Account?
An Overdrawn Director’s Loan Account happens when a director owes the company money. This comes about when the company makes profits and the accountants advise on saving tax and keeping National Insurance at low levels, by paying directors a small salary but the company doesn’t have requisite reserves. Normally, directors take drawings every month from the reserves of profits in the past and current months but the problems start when the company stops making profits.
Usually, at the end of each month, quarter or year, the board vote on paying dividends to the shareholders. This way the drawings are cancelled and the dividends are voted through to cover the drawings.
Such an account is not too bad, so long that you can afford to repay it and keep track of the transactions. It becomes more of an issue when the business starts to perform poorly…directors can even 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. When the director’s loan account becomes overdrawn, it is classed as a company asset.
To avoid the account fitting the ‘overdrawn’ category, the loan must be paid back within 9 months of the end of the accounting period.
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. 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. Though you intend to pay it back, it rarely ever is!
A director can borrow from their 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 and National Insurance Contributions.
What can be done about the director’s loans if the company goes into any form of insolvency?
If a company goes into a form of insolvency and the loan account is outstanding, (which for three quarters of insolvent companies a DLA is likely to be involved) the appointed liquidator will look to recover the debt for the benefit of the creditors, as of course, they will be acting with the creditors interests at heart.
In such circumstances options include:
- Repaying the director’s loan, as ultimately you owe the company
- 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 and remembering 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. It is a liquidators duty to not let this be ignored and ensure the loan is repaid…it is not a way to avoid paying creditors.
What are the Tax Implications?
When taking money from the company, it must be classed as a tax, being subject to a tax charge. This is because the company has lent money to you i.e. it is a benefit which is not a part of your salary. This is known as ‘Benefit in Kind’. HMRC see it as an interest-free loan as you are benefitting from it hence the reference, ‘beneficial loan’. However, this is not for all cases; if the loan is under £10,000, if the company charges the director interest and/or if the loan is used for certain purposes such as purchasing an interest in a partnership.
Moreover, if the overdrawn directors loan account exists in the nine months after the end of the company’s accounting period, a penal rate of tax known as Section 455 of S455 will be charged at a rate of 25%. Read more about S455 here.
S455 is charged, corporation tax or not, if your business has made a profit, seen a loss, or has already paid its tax…no exemptions. Only if the charge is paid on time (9 months after the company’s year-end) can you have the payment refundable (but as you can imagine, this is is a long-winded process!).
If you cannot repay the loan account nine months and a day after the company’s year end, HMRC charge interest on the loan which adds up until the S455 corporation tax or the director’s loan account is repaid. Only the corporation tax can be reclaimed at a later date, not the interest (at a rate of between 3-4%) paid.
In summary, the director will be taxed on the benefit received.
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 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 to take dividends from reserves and future profits. They did this for several years and paid themselves 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.