A director’s loan account is used to record transactions between the company and its directors. An overdrawn director’s loan account is simply a loan that the director took out of the company that has not been repaid. This can cause significant problems for a limited company that is starting to fail financially.
It is not unusual for the directors of limited companies to take out drawings from the business in some form other than salary or a dividend. If the directors decide to do this, any money taken from the business is considered to be a loan from the company, and it must be repaid just like any other loan. Any money taken out of the business is subject to scrutiny because a limited company is a separate business entity that is legally and financially separate from its owners.
How it works
If you don’t take any money out of the company (apart from salary and dividends), then the director’s loan account will have a zero balance. If you pay personal money into the business (for example to buy inventory or equipment), there will be a credit balance in the account and the company will owe you money. Conversely, if you draw money out of the company, the director’s loan account will be in debit – meaning it is an asset of the company because this money will be owed back and must be repaid.
An overdrawn director’s loan account is not necessarily a problem, as long as the balance is repaid within nine months of the end of the accounting period. Problems may arise when the balance is not repaid within that time-frame, or if the business starts performing poorly and cannot keep up with obligations, becoming insolvent.
If the director’s loan account is not repaid within 9 months of the company’s year-end, the unpaid director’s loan will lead to serious tax implications. Having an overdrawn director’s loan account while the company is insolvent can lead to severe penalties and personal liability.
Tax considerations
Your company tax return must disclose an overdrawn director’s loan account if that is the case, and the company will have to pay corporation tax on any amount that has not been repaid nine months after the end of the company’s accounting period. It is important to include all entries to the director’s loan account in a timely manner and it must be accurate. HMRC can question you about the status of a director’s loan account at any time as part of a tax compliance inspection.
As stated above, if you have an overdrawn director’s loan account, then you owe the company money. Failure to repay the amount owed within nine months after the end of the accounting period will incur a corporation tax penalty of 32.5% of the loan. If the sum owed is over £10,000 and the loan is interest-free, or is charged at less than commercial rates, HMRC will view this as money taken out as income. This means there will also be income tax and national insurance implications to consider, and HMRC will also charge interest on the loan until the corporation tax levied on the loan or the director’s loan account is repaid.
What happens to an overdrawn director’s loan account in insolvency?
A company may try to reduce or clear the director’s loan account balance by classing it as dividends, or perhaps a bonus. However, it could cause problems further down the line if the company becomes insolvent. Legal proceedings can be taken against the directors, and they may become personally liable to repay the amount.
When a company is insolvent, the liabilities exceed the assets, and creditors usually only get back a fraction of what they are owed. During the liquidation process, the liquidators are required to do due diligence and investigate the nature of any transactions between the company and the directors. Their job is to bring about a return to the company’s creditors, therefore any money that is owed to the company needs to be collected in order to increase the repayment to the creditors as much as possible.
The liquidator’s job is to take action and attempt to recover the director’s loan. If the directors of the company are unable to repay the amount, their personal assets are at risk and legal action could be taken against the directors, ultimately forcing them into bankruptcy. The situation could be especially problematic if the insolvency process is started by a creditor, for example a supplier or HMRC, rather than entering into liquidation voluntarily.
If the liquidation is compulsory, it will be the Official Receiver who liquidates the company, and they will need to look closely at all the circumstances that lead to an overdrawn director’s loan account. This could lead to allegations of wrongful trading, misfeasance, or even fraud, and it could lead to a ban from acting as a company director for a period of up to 15 years.
Can the balance on an overdrawn director’s loan account be written off?
In some instances yes, the balance can be reduced for various legitimate reasons. For example, if a director paid for a company’s vehicle repairs with their own personal money, or if inventory or other assets were bought for the company but paid for with personal funds.
In other circumstances a director’s loan account can be completely written off. For example, in a company of fewer than five shareholders (known as a ‘close company’), if the director is also a shareholder an overdrawn director’s loan account can be treated as a distribution of profits and therefore written off. If the director is not a shareholder, the outstanding amount in the account will be taxed as employment income, in which case this must be included in the director’s own tax return.
Although this will not necessarily be the end of the matter, because the liquidator has a legal duty to pursue any possible option that could increase the repayment due to the company’s creditors, even if the director’s loan account had been previously written off.
If you have any questions or concerns, or you simply want to know more about director’s loan accounts, then feel free to give Lucas Ross a call on 0330 128 9489 or email us at help@lucasross.co.uk as we may be able to help.
