A director’s loan account is a complex matter for directors to make sense of – taking money out of the business is simple when it is a partnership or you are a sole trader, but with a company being a separate legal entity, it makes withdrawing money from companies more complicated.
Anyhow, the director's loan account is a record of the transactions between the director and the company itself, excluding salary and dividends.
An overdrawn director's loan account is created when the director takes money out of the company, by the form of a loan, resulting in the director owing the company money. When the amount extracted is more than what can be put back in, the account is overdrawn.
Ultimately, DLAs can be a handy feature, so long you can afford to repay it and keep on top of all transactions. It is less useful and more of an issue when the business starts to perform poorly, bringing potential personal liability problems for directors.
Why 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 tax rate. Dividends can be paid out of what are called distributable reserves. Normally, directors would 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.
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 MUST 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 to credit, only if the money is paid into the company bank account (not if shares are brought).
If you loan money to your company with interest then the interest must be declared as income when filing a Self-Assessment form.
If you borrow money from the company, keep in mind that it needs to be repaid. Often, this is the intention but rarely does it actually happen. Anyhow, money can be borrowed from a company by the director so long that the company is 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.
Benefit in Kind loans exist. This is when the company lends you money, but the benefit is not included in your salary, therefore you do not need to pay tax on it. However, HMRC see it as an interest-free loan since you are benefiting from it. Note: If the company does charge interest on the loan then it can be seen as a commercial loan. If the loan is below £10,000 and if the director’s loan is used for certain purposes which qualify, purchasing an interest in a partnership for instance, then it won’t qualify as a Benefit in Kind loan.
Do Director's Loans need to be paid back?
Yes!! Of course – they need paying back, as does any other type of loan. If the director’s loan is repaid within 9 months of the end of the accounting period then the classification of being overdrawn is removed.
There are implications if the loan is not paid back:
- Charged a Corporation tax penalty of 32.5% of the loan amount,
- National Insurance and Income tax implications (for loans exceeding £10,000),
- Pushed to personal bankruptcy (since you are unable to pay back the money you withdrew from the company)
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?
As mentioned briefly above, when taking money from the company, it must be classed as a tax, so is subject to a tax charge.
If the overdrawn directors loan account remains after the period of which it needs to have been repaid, then a penal rate of tax of S455 (known as Section 455) will be charged at a rate of 32.5% (or 25% for loans before 6 April 2016). 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 amount 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.
For filing accounts, disclosure of the real appearance of the account is crucial. 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.
Remember – to avoid the account becoming overdrawn, ensure to re-pay the loan within 9 months of the end of the accounting period. If not, the overdrawn loan account becomes a company asset.
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 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 - 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
It is vital to remember, if your company is insolvent, dividends must not be taken from the company accounts as this will worsen and add to the current overdrawn director’s loan account.
What Happens to the Director's Loan Account in Liquidation or Insolvency?
The liquidator can 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 – yes your own personal means may need to be ascertained by the liquidator! It is a liquidator’s duty to ensure the loan is repaid...Liquidation is not a way to avoid paying creditors.
If you cannot pay back the owed money then you may be forced into personal bankruptcy. Additional to this, the insolvency practitioner has a duty to investigate the conduct of you, as the director, in the lead-up to the companies liquidation. The result could be disqualification of being a director of another company, for up to 15 years.
A case study on an Overdrawn Directors' Loan Account
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.
Though, 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 as being 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 customers.
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 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?
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Please note that the guide includes updates due to Covid-19 For instance there have been some changes to insolvency legislation that limits creditors actions and relaxes rules regarding wrongful trading. A new 20 day moratorium for distressed businesses has also been introduced.