One of the principles in business most often misunderstood is that a limited company’s financial affairs and those of its directors and shareholders are separate. A limited company is a distinct legal entity and, for this reason, there are clear rules governing how funds lent to directors must be dealt with. This is where the Director’s loan account (DLA) comes in. However, how this type of loan account functions, particularly if a company becomes insolvent, is also misunderstood. Here, we clarify DLAs and their potential pitfalls.
How does a Director’s loan account (DLA) arise?
There are two main scenarios, of which the first is simply where money, goods or services are provided to Directors by a company and have not yet been paid for or repaid. The other cause can be where a Director draws a regular monthly amount from a company, partly against a relatively low basic salary and partly on account of a dividend to be declared at the end of the year out of profits. This is essentially a tax planning arrangement, which will leave the Director’s loan account temporarily overdrawn until the dividend can be declared or for longer if profits are insufficient to enable a lawful dividend to be declared to clear the debt.
What are the rules for a Director’s loan account?
An overdrawn DLA is not illegal, but there is a requirement to obtain prior shareholder approval for the original advance if it is more than £10,000. This will be a formality where the Director is the controlling shareholder. However, it will have tax and disclosure consequences if the DLA remains overdrawn for longer than nine months after the end of an accounting period. The only exceptions are if the company is a lender in the ordinary course of its business or if the company is a close company (see below), to which some limited technical exemptions apply.
Close companies and DLAs
A close company is one controlled by five or fewer participators or by any numbers of participators if those participators are the directors of the company. Different rules apply to close companies as regards DLAs.
With close companies, payments made to a director’s family, friends, business partners or any persons associated with the director may need to be recorded as part of a Director’s loan account. Also, an overdrawn DLA cannot be avoided by lending money instead to a person connected with the director.
Overdrawn DLAs in a close company will not attract a potential tax charge under two circumstances:
- where the debt has arisen from the supply of goods and services in the ordinary course of its trade unless the credit given exceeds six months or is longer than normally given to the company’s customers;
- if a loan made to a director or employee of a close company does not exceed £15,000, the borrower works full time for the company and the borrower does not have a material interest in the company. A person has a material interest in a company for this purpose if together with any associate they are able to control more than 5% of ordinary share capital.
Tax issues on a Director’s loan account
Benefit in kind
If the overdrawn balance is greater than £10,000, a benefit in kind will arise on the cash equivalent of the amount of interest that would be payable at the official HMRC rate, unless the Director has paid interest at that rate or higher.
Corporation tax charge
If the Director’s loan account remains overdrawn nine months after the end of the company accounting period, there will be a tax charge at the rate of 32.5% on the lower of the amount outstanding at the year end and nine months after the year end.
This amount is payable even if the company is making a loss and there is no other corporation tax due. It is a temporary tax, repayable to the company by HMRC nine months after the end of the accounting period in which the loan was repaid. Once the loan is repaid the overall tax effect is neutral but the gap between the initial tax payment and the eventual refund could place a significant strain on the company’s cash flow.
Companies Act 2006 Section 413 provides for disclosure in a company’s accounts of the details of any advance or credit granted by a company to its directors. The details to be shown are the amount of the loan granted during the year, an indication of the interest rate, its main conditions and any amount repaid or written off. The notes to the accounts must also show the gross amount of the loan and the total amount of interest charged. An overdrawn DLA must also be disclosed in the company’s Corporation Tax Return.
Related article: HMRC petitions and debt recovery: What directors need to know
Can an overdrawn Director’s loan account be written off?
The company can write off a loan or overdrawn balance on a Director’s loan account. This must be formally waived and documented as such, because the liability will technically remain if the company simply agrees not to collect the outstanding balance.
The amount written off is treated as though it was dividend (a ‘deemed dividend’). Because it is a deemed dividend there is no requirement for the company to have available profits for distribution and an equivalent dividend does not need to be paid to the other shareholders of a particular class of shares.
However, an important feature of a DLA being written off is that in most cases, HMRC will claim that the amount of the write off qualifies as ‘emoluments from an office or employment’ and look to collect Class 1 NIC from the company.
The amount of loan written off should be included in the Director’s self-assessment tax return on a specific box on the ‘additional information’ pages. For income tax purposes the amount is treated as dividend income. The company will not receive corporation tax relief on the amount of the loan or balance written off.
What are the consequences of an overdrawn Director’s loan account if the company goes into Administration or Liquidation?
Repayment of the overdrawn balance
The Administrator or Liquidator can demand that the director repays the amount owed to the company in order to pay the company’s creditors and, if necessary, take enforcement action to recover the debt including petitioning for the Director’s bankruptcy.
Wrongful Trading and Director Disqualification
In extreme cases, amounts withdrawn by a director could be held to have caused or contributed to the failure of the company and to have increased losses suffered by creditors. This could trigger action under a range of penalties available as sanctions against Directors, most notably under the Wrongful Trading provisions of the insolvency legislation. It could also be grounds for the disqualification of the Director.
How we can help
If you are looking for advice or support in regards to DLAs and their handling during administration or liquidation, please do get in touch.
We have extensive experience of these scenarios. One of our Partners would be more than happy to have a non-obligatory confidential chat with you. We can be contacted at firstname.lastname@example.org or call us on 020 3326 6454 and we will arrange for a call with one of our Partners.