How Do You Solve A Problem Like An Overdrawn Director’s Loan Account?

Introduction To How Do You Solve A Problem Like An Overdrawn Director’s Loan Account

How Do You Solve A Problem Like An Overdrawn Director’s Loan Account? Perhaps one of the most notable small company director’s trials and tribulations is an overdrawn director’s loan account. Hindsight is a wonderful thing if someone were to say do not go overdrawn, pay tax on salary as you go along if you cannot declare dividends to clear it.

The problem with an overdrawn director’s loan account is it risks turning into the proverbial bar of soap that a small company director might never manage to grab hold of once it has been let loose and slips away. 

It can become a corporate way of life for many small company directors, uninterrupted in many instances, lying dormant until it erupts perhaps upon a company going into insolvent liquidation when the liquidator holds out their hand and asks for it to be repaid. 

It does not have to be a problem, particularly for a successful company. However, hidden risks CAN lurk if it amounts to too much of a company’s assets sitting on the balance sheet.

The potential problem for many directors is they might not even be aware (regardless of obligations) that their overdrawn director’s loan account is a potential Titanic that risks careering into an iceberg.

What Is An Overdrawn Director’s Loan Account?

The clue is in the word overdrawn which comprises the words over and drawn. 

It amounts to the taking out of drawings from a company and going over the entitled amount. This creates a balance owed from the director to the company. That is the overdrawn director’s loan account. This suggests perhaps it might not be the most ideal state of affairs.

The association with an overdraft can lead to suggestions of some similarity to being overdrawn at the bank. Whilst both are a balance owed from one party to another, that is where the similarity seemingly ends. The small company director does not usually have to undergo the rigour of a credit check in order to extract a director’s loan from a limited company. They would not typically be subject to the oversight of a credit committee. They usually in effect are the credit committee of the company on whose board they may sit.

Typically it may arise from a director doing nothing more than transferring money sitting in the company’s bank account to their own personal bank account to then use to live off and pay their bills.

What Are The Problems With An Overdrawn Director’s Loan Account?

The current statutory framework permits overdrawn director’s loan accounts. This is perhaps potentially where a problem may lie. The lack of independence an owner managed small company director has from their company is unsurprising. If someone else besides the directors were after a loan or credit from it then a different approach might be a proposition to ponder.

Director’s duties require a director under Section 172 of the Companies Act 2006 to in effect avoid conflicts of interest by acting in the best interests of the company. Such a rule is capable of being overridden or relaxed by ratification. It is conceivably this arguable inconsistency that may appear to blur some of the lines of a limited liability company. Absent a personal guarantee you might struggle to find a more apparent severing (perceptionally only) of the separation between a limited company and its directors than the effect of an overdrawn director’s loan account. 

The more exceptions that are available and the more complicated the rules are, perhaps the greater the scope for them to be misunderstood. If on the other hand, the legislation created a clear dividing line then perhaps the problems of an overdrawn director’s loan account could be avoided or reduced. 

Whilst the barrier between the company and its director is without question maintained; it is the deployment of company resources to the potential detriment of the company that is perhaps notably striking and where an overdrawn director’s loan account problem potentially truly lies. 

The government could conceivably legislate to outlaw the practice of a director having an overdrawn director’s loan account. This might reinforce (perceptionally only given the separation legally is not in doubt) the separate legal person status that Salomon v Salomon & Co Ltd [1896] UKHL 1 highlighted for a company compared to its incorporators:

… once the company is legally incorporated it must be treated like any other independent person with its rights and liabilities appropriate to itself …

Change To The Law Of Director’s Loan Accounts

This used to be the practice in Section 330 of the 1985 Companies Act 1985 which was eroded when the Companies Act 2006 became law.

It is unclear if this was a success or not but perhaps worrying is the prevalence of overdrawn director’s loan accounts in companies in liquidation. Up to 75% of directors have an overdrawn director’s loan account on liquidation according to the article “Understanding Overdrawn Director’s Loan Accounts – Including Repayment, Interest & Tax” of Real Business Rescue, which is part of a group that conceivably does more creditors voluntary liquidations than anyone else in the country. Certainly, if you scan the Gazette for such liquidation types and then train your sights on the Statement of Affairs at Companies House you will likely not need to look through many before the overdrawn director’s loan account sprouts in an asset section of the document.

Problem For The Director Of An Overdrawn Director’s Loan Account

The problem with an overdrawn director’s loan account for a director is the day might come when it has to be repaid and that can be at short notice. This can happen after they become aware of the issue upon preparation of the annual accounts with a decision required to write it off by flipping the tax burden on it to their personal tax affairs or if the company goes into liquidation and they are called upon to repay it.

The overdrawn director’s loan account is written off by the company then the director suffers income tax on the amount written off in light of Section 415 of the Income Tax (Trading and Other Income) Act 2005.

If a director is unprepared and without sufficient cash to repay it they may risk being forced into personal bankruptcy. 

Problem For The Company Of An Overdrawn Director’s Loan Account

The problem for a company is the tax on an overdrawn director’s loan account (rate of 33.75% from 6 April 2022) that has to be paid if the loan has not been repaid by the director within nine months and one day of the year end. 

Does Taxation Act As A Solution?

Taxation is not a likely solution to an overdrawn director’s loan account because tax is raised materially in arrears. Other than preventing the abuse of overdrawn director’s loan accounts as a means of extracting remuneration from a company tax free, the tax system arguably could be said to do little to discourage the practice. 

A company’s annual accounts required by legislation do not have to be filed until 9 months after the year end. Long after an overdrawn director’s loan account might be discovered for many small companies that only do accounts and bring their books up to date once a year.

By then the potential problem exists and yes taxes are levied. However, tax only hits a proportion of the problem in any event as of course you are not taxed at the rate of 100% but at 33.75% of the overdrawn increase in the period. Once a director becomes aware of this they have a choice either cause the company to pay the Section 455 tax or repay the overdrawn director’s loan account. Perhaps unsurprisingly many might opt for the cheaper option, particularly if cash is in short supply. Even if the director repays the loan and the company can reclaim the Section 455 tax by virtue of Section 458 of the Corporation Tax Act 2010 there is a long potential delay before the HMRC repays it to the company. It is only repayable 9 months after the accounting period in which the repayment is made.

By this stage, the prospect is that the overdrawn director’s loan account which may encapsulate many of the attributes of the risks of living off an overdrawn director’s loan account is not necessarily confined to the accounting period (typically 12 months) but may well have stretched to nearly 21 months of drawings. Remember you do not have to file accounts until 9 months after the year end before falling foul of the criminal offence of the failure to file accounts at Companies House on time. By then the risk is the pattern of accounting behaviour could now be entrenched and tricky to reverse.

The tax legislation appears reactive to the risk of potential tax avoidance of directors taking loans from companies but it is potentially arguably levied too late in the day. It is conceivably not realistic for a small company director to file accounts monthly but if a director was aware of the issue one month after the commencement of trading perhaps it might never turn into that slippery bar of soap.

Reduced Transparency Risk For Trading Partners

An overdrawn director’s loan account can fetter the ability of a party who wishes to consider trading with a company from assessing their risk. 

As a matter of accounting an overdrawn director’s loan account sits on the balance sheet typically within ‘Other Debtors’ but if it is a company’s material asset then the creditor worthiness of the company might be difficult to assess. 

It is all very well being able to see the balance sheet of the company at Companies House but the potential trading partner cannot see the personal balance sheet of the director who is overdrawn.

Although you can clear a director loan account perhaps prevention is better than cure. Save for the successful company that can afford to pay the Section 455 tax or the director who can readily afford to repay it on demand it is not unknown for it to develop into a serious problem.

The crux of the problem of an overdrawn director’s loan account is that for many small company directors, it represents the drawings that they need to pay bills and support their standard of living. However, taking a step back it could potentially present a significant cash flow problem. Granted that the director does not pay income tax on it in their personal self assessment tax return if Section 455 tax is paid by the company but consider this conceivably unhappy reality – the company has paid tax and notwithstanding that position, the director is still liable in full for the overdrawn director’s loan account to the company. 

Is the better option not to pay a salary instead if an owner managed company cannot declare dividends, have the company pay the tax on that as you are going along? This COULD potentially limit the exposure to higher rate taxes compared to a one off writing off of the overdrawn director’s loan account. Obviously that does depend on the individual’s personal tax affairs.

A potential solution appears simple enough apart from perhaps the matter of a director sitting a test to act as one for the first company to ensure they are well aware from day one of this issue. Simply reinstate the outlawing of its occurrence and the problem could perhaps materially reduce. However, has the Companies Act 2006 relaxed matters leaving us unable to put the genie back into the bottle?

Even so, even if we could reinstate the position in the Companies Act 1985, what about enforcement? Without it how could such a common corporate problem be solved?