Overdrawn directors’ loan accounts – why it can be a big problem and how to avoid it.
If you are a company owner and you don’t understand your directors loan account, and the implications of having a debit directors’ loan account you could lose not just your company but your own assets as well.
You own 100% of the issued share capital of your company. You are the sole director of the company. No one else has any decision making authority over the company and the company has no debt. It is clearly your company and so you think of the company assets as your own assets. This is an attitude that is not only misguided; it has the potential to be catastrophic.
The first thing to understand is that you are not your company. In the eyes of the law your company is a separate legal entity. It has the power to enter into legally binding contracts in its own right, to earn money and to own assets. This is covered in more detail in You are not your company. It is very important to understand this point, so if you aren’t sure you fully comprehend it I urge you to read to read it.
For now it is sufficient to understand that although you may own 100% of the company, the assets of the company are not your own assets until you transfer them out of the company and into your own name. If you use the assets of the company for your personal gain you may need to declare that gain on a P11D and pay personal tax on it. This is all spelled out in You are not your company.
All about Directors’ Loan Accounts
A directors’ loan account is what is owed between the company and the director. If it is in credit the company owes the director. If the director owes the company it is in debit.
Most company founders, when they start a company, contribute some money to the company to pay for start-up costs and to give the business a bit of cash to get started. You may have done this without fully understanding it and just let your accountant deal with it. That is not uncommon. The usual form of a founders’ initial cash injection is a small amount of share capital (often one or two pounds) and the rest of the money is a non interest bearing directors loan. It is not required by any law or regulation that you do it like this, but it is the most common and the simplest.
If this is how you’ve set up your company then on day one your company has a credit directors’ loan account. The share capital is your ownership stake in the company. It is what signifies that you own the company, and if you were the only one to contribute share capital on formation of the company then you own 100% of the company. You can’t get the share capital back without either selling your stake in the company or winding the company up.
On the other hand, the credit directors’ loan is money the company owes you. At any time you can take that money back from the company. Right? Well not quite, and it is important you understand why, so I’ll explain in shortly.
Most of the time when a director puts money (or any other assets) into a company it will increase the credit loan account, ie the company will owe you more money. You can also make a share capital contribution but it’s less common so I won’t cover it here.
For tax purposes company directors often remunerate themselves with a combination of wages and dividends from their company, but don’t actually transfer the cash out of the company. Along with physically paying money into the company and paying expenses on behalf of the company these are the most common credits to a directors’ loan account.
On the other hand, whenever a director takes money (or any other assets) out of the company, if it is not accounted for as wages or dividends it is a debit, or a repayment of the director’s loan account. This is not an issue as long as there is sufficient owing to the director to withdraw. However many directors use their company loan account like their personal bank account, leaving the accountant to pick up the pieces. If this leaves the loan in debit it can cause real problems.
Debit loan accounts
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Assuming that the director is aware of this situation within 9 months of the company year-end it is possible to rectify the situation without any serious harm being done. If the director has sufficient funds they can simply repay the company. Alternatively the company can pay wages or dividends to the director and credit them to the loan account rather than paying cash to the director. However this will clearly have personal tax implications for the director and also in the case of wages could have PAYE liability consequences for the company.
Furthermore, if a company director is disorganised enough to end the financial year with a debit loan account there is a good chance they are also not going to complete the company accounts within 9 months. This means the window of opportunity to rectify the situation is lost.
In this situation it is likely that HMRC will want to know why.
In order for a company to have a debit loan account with a director:
· The company must be solvent
· It must be in adherence with the company’s articles of association
· It must comply with the Companies Act 2006
· If it is over £10,000 a board resolution must be passed giving consent
· If the funds are required by the company the loan can be no more than £50,000.
If a directors debit loan account is not repaid by nine months after the company year end the company will be liable to pay S.455 corporation tax. This tax is declared on the company’s tax return and it is levied at 32.5% of the outstanding loan.
While this sounds extraordinarily punitive it is actually not as bad as it seems, and by no means the worst consequence of a debit loan account. This is because if the director does repay the debit loan account the S.455 tax can be reclaimed by submitting a form LP2. However it will only be repaid 9 months after the end of the next company tax year, so the company could have to wait up to 21 months to get the cash back.
A benefit-in-kind is a non cash payment to an employee or director.
In the case of a debit loan account the director has benefited from a non cash benefit – an interest free loan. This loan will need to go on the directors P11D and personal tax will need to be paid on it. The benefit is calculated as the interest that would have been paid on the loan using HMRC’s published rate. The most recent HMRC rate was 2.5%, so on a £10,000 loan the director would have to pay tax at their marginal rate on £250.
While this may sting a little bit, things could still get far worse.
As our disorganised director has been taking money out of the company he has probably been spending it, and not thinking about the personal tax consequences. If he has to declare all of his drawings as wages and dividends and he doesn’t have the cash to pay the tax on these he has a problem. But the real doomsday scenario is where the company has been profitable, and therefore has tax to pay, but the director has taken all of the money out.
If the director has taken too much money out of the company and left it unable to pay its tax bills he may be in breach of his fiduciary duties as a director. For more detail on this see The seven things all company directors must know and why it’s necessary. This is where things start to get really bad.
If a director is in breach of their duties as a director the protection from personal litigation that the company gives them can be lifted, meaning they could be at risk of losing their personal assets. Also, if a company is unable to pay its debts then its creditors can appoint a liquidator and have the company wound up. Even if your company is not taking out loans you need to be aware of this as unpaid corporation tax is a debt and HMRC have a history of winding up companies that fail to pay their tax.
Once a debit loan account has been outstanding beyond nine months after year end there is not easy solution but to pay the benefits in kind tax and pay the S.455 tax. Then hopefully the director can take enough wages and dividends out of the company, pay personal tax on them and then repay the loan and eventually get the S.455 tax back.
This is not a tax efficient way to operate. The answer is to keep on top of your directors loan account at all times throughout the year. And the way to do this is using the LCCS Live Tax Report.
The LCCS Live Tax Report is a very simple to use tool available to all LCCS clients on the LCCS website. It can be used as frequently as you like, but we recommend you at least use it every time you wish to withdraw month from your company. It only takes a minute to enter a few simple numbers like company earnings, company costs and other earnings the director has had outside of the company. The instantly generated report then advises how much corporations tax is owed on the current earnings, how much the director can safely take out of the company and how much personal tax the director will need to pay. This way the director avoids ending the year with a debit loan account and knows exactly how much money to put aside for tax, so there is no nasty surprises or unaffordable tax bills come tax time.
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Overdrawn directors’ loan accounts – why it can be a big problem and how to avoid it.
If you are a company owner and you don’t understand your directors loan account, and the implications of having a debit directors’ loan account you could lose not just your company but your own assets as well.
You own 100% of the issued share capital of your company. You are the sole director of the company. No one else has any decision making authority over the company and the company has no debt. It is clearly your company and so you think of the company assets as your own assets. This is an attitude that is not only misguided; it has the potential to be catastrophic.
The first thing to understand is that you are not your company. In the eyes of the law your company is a separate legal entity. It has the power to enter into legally binding contracts in its own right, to earn money and to own assets. This is covered in more detail in You are not your company. It is very important to understand this point, so if you aren’t sure you fully comprehend it I urge you to read to read it.
For now it is sufficient to understand that although you may own 100% of the company, the assets of the company are not your own assets until you transfer them out of the company and into your own name. If you use the assets of the company for your personal gain you may need to declare that gain on a P11D and pay personal tax on it. This is all spelled out in You are not your company.
All about Directors’ Loan Accounts
A directors’ loan account is what is owed between the company and the director. If it is in credit the company owes the director. If the director owes the company it is in debit.
Most company founders, when they start a company, contribute some money to the company to pay for start-up costs and to give the business a bit of cash to get started. You may have done this without fully understanding it and just let your accountant deal with it. That is not uncommon. The usual form of a founders’ initial cash injection is a small amount of share capital (often one or two pounds) and the rest of the money is a non interest bearing directors loan. It is not required by any law or regulation that you do it like this, but it is the most common and the simplest.
If this is how you’ve set up your company then on day one your company has a credit directors’ loan account. The share capital is your ownership stake in the company. It is what signifies that you own the company, and if you were the only one to contribute share capital on formation of the company then you own 100% of the company. You can’t get the share capital back without either selling your stake in the company or winding the company up.
On the other hand, the credit directors’ loan is money the company owes you. At any time you can take that money back from the company. Right? Well not quite, and it is important you understand why, so I’ll explain in shortly.
Most of the time when a director puts money (or any other assets) into a company it will increase the credit loan account, ie the company will owe you more money. You can also make a share capital contribution but it’s less common so I won’t cover it here.
For tax purposes company directors often remunerate themselves with a combination of wages and dividends from their company, but don’t actually transfer the cash out of the company. Along with physically paying money into the company and paying expenses on behalf of the company these are the most common credits to a directors’ loan account.
On the other hand, whenever a director takes money (or any other assets) out of the company, if it is not accounted for as wages or dividends it is a debit, or a repayment of the director’s loan account. This is not an issue as long as there is sufficient owing to the director to withdraw. However many directors use their company loan account like their personal bank account, leaving the accountant to pick up the pieces. If this leaves the loan in debit it can cause real problems.
Debit loan accounts
*You can unsubscribe at any time here.
**If you want to comment on any of our articles you will need to create an account here.
Assuming that the director is aware of this situation within 9 months of the company year-end it is possible to rectify the situation without any serious harm being done. If the director has sufficient funds they can simply repay the company. Alternatively the company can pay wages or dividends to the director and credit them to the loan account rather than paying cash to the director. However this will clearly have personal tax implications for the director and also in the case of wages could have PAYE liability consequences for the company.
Furthermore, if a company director is disorganised enough to end the financial year with a debit loan account there is a good chance they are also not going to complete the company accounts within 9 months. This means the window of opportunity to rectify the situation is lost.
In this situation it is likely that HMRC will want to know why.
In order for a company to have a debit loan account with a director:
· The company must be solvent
· It must be in adherence with the company’s articles of association
· It must comply with the Companies Act 2006
· If it is over £10,000 a board resolution must be passed giving consent
· If the funds are required by the company the loan can be no more than £50,000.
If a directors debit loan account is not repaid by nine months after the company year end the company will be liable to pay S.455 corporation tax. This tax is declared on the company’s tax return and it is levied at 32.5% of the outstanding loan.
While this sounds extraordinarily punitive it is actually not as bad as it seems, and by no means the worst consequence of a debit loan account. This is because if the director does repay the debit loan account the S.455 tax can be reclaimed by submitting a form LP2. However it will only be repaid 9 months after the end of the next company tax year, so the company could have to wait up to 21 months to get the cash back.
A benefit-in-kind is a non cash payment to an employee or director.
In the case of a debit loan account the director has benefited from a non cash benefit – an interest free loan. This loan will need to go on the directors P11D and personal tax will need to be paid on it. The benefit is calculated as the interest that would have been paid on the loan using HMRC’s published rate. The most recent HMRC rate was 2.5%, so on a £10,000 loan the director would have to pay tax at their marginal rate on £250.
While this may sting a little bit, things could still get far worse.
As our disorganised director has been taking money out of the company he has probably been spending it, and not thinking about the personal tax consequences. If he has to declare all of his drawings as wages and dividends and he doesn’t have the cash to pay the tax on these he has a problem. But the real doomsday scenario is where the company has been profitable, and therefore has tax to pay, but the director has taken all of the money out.
If the director has taken too much money out of the company and left it unable to pay its tax bills he may be in breach of his fiduciary duties as a director. For more detail on this see The seven things all company directors must know and why it’s necessary. This is where things start to get really bad.
If a director is in breach of their duties as a director the protection from personal litigation that the company gives them can be lifted, meaning they could be at risk of losing their personal assets. Also, if a company is unable to pay its debts then its creditors can appoint a liquidator and have the company wound up. Even if your company is not taking out loans you need to be aware of this as unpaid corporation tax is a debt and HMRC have a history of winding up companies that fail to pay their tax.
Once a debit loan account has been outstanding beyond nine months after year end there is not easy solution but to pay the benefits in kind tax and pay the S.455 tax. Then hopefully the director can take enough wages and dividends out of the company, pay personal tax on them and then repay the loan and eventually get the S.455 tax back.
This is not a tax efficient way to operate. The answer is to keep on top of your directors loan account at all times throughout the year. And the way to do this is using the LCCS Live Tax Report.
The LCCS Live Tax Report is a very simple to use tool available to all LCCS clients on the LCCS website. It can be used as frequently as you like, but we recommend you at least use it every time you wish to withdraw month from your company. It only takes a minute to enter a few simple numbers like company earnings, company costs and other earnings the director has had outside of the company. The instantly generated report then advises how much corporations tax is owed on the current earnings, how much the director can safely take out of the company and how much personal tax the director will need to pay. This way the director avoids ending the year with a debit loan account and knows exactly how much money to put aside for tax, so there is no nasty surprises or unaffordable tax bills come tax time.
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