Why Should You Sort Out An Overdrawn Director’s Loan Account Without Delay?

The reason you should sort out an overdrawn director’s loan account without delay is because it is not going away and there can be significant tax implications for the company and the director personally.

The longer an overdrawn director’s loan account is left unaddressed the risk is that it just keeps increasing which can be storing up an even bigger debt that the director is personally liable to repay to the company.

What Is An Overdrawn Director’s Loan Account?

An overdrawn Director’s loan account is the position that arises when the monies taken out of a company by a Director and paid back or on behalf of the company are worked out. This creates the ‘account’ or in accounting terminology, it is called the ledger. When you take out the calculator and they are added up and subtracted you end up with a balance. That is the balance on the Director’s loan account.

Either the Director’s loan account is in credit which means that the company owes the Director money. Alternatively, it is in debit or more commonly referred to as being overdrawn in which case the Director owes money to the company. This article concentrates on the second situation when a company Director cannot pay their overdrawn Director’s loan account.

A Director’s loan account that is overdrawn is an asset of the company. It is essentially no different from being overdrawn with the bank. The difference is instead of owing the bank, you owe the company.

What To Sort Out With An Overdrawn Director’s Loan Account?

A Director needs to address the balance on the overdrawn director’s loan account

To sort out an overdrawn director’s loan account a Director needs to know the balance that they owe to the company. 

They need to analyse the company’s bank statements to identify all the monies they have lent to the company and all the money they have taken out. However, it is not merely a matter of monies flowing to or from a Director. Monies withdrawn may be for salary, dividends and expenses (and loans) incurred by a Director personally for the company which are items a Director will be owed by the company. 

To work out the overdrawn director’s loan account balance, all monies a Director is entitled to need to be deducted from the sums a Director has received from the company. 

Why Should You Sort Out Repayment Of An Overdrawn Director’s Loan Account?

It prevents a Director from getting into more and more debt with the company due to an overdrawn director’s loan account

Typically an overdrawn director’s loan account arises when a company cannot declare a dividend to justify the Director’s receipt of money they regularly take from the company to live off. 

It is often considered a more tax efficient way to remunerate a Director because the company does not pay Employer’s National Insurance on dividends. A company will have to pay Employer’s National Insurance if the Director is instead being paid by a company by way of a salary.

However, if a Director is trying to solve company cash flow problems then one strategy might be to reduce the liability the company has to HMRC for PAYE and National Insurance. Instead of drawing a salary, they may choose to build up an overdrawn director’s loan account. This will particularly be an issue if the company does not have sufficient distributable reserves, as any dividend would be an unlawful dividend and have to be repaid.  

The problem is that whilst HMRC tax liabilities for PAYE and National Insurance may be reduced for the company, the trade off is the Director will at some point have to repay the overdrawn director’s loan account. In many instances, this will be a temporary measure to give the company a breathing space whilst it attempts to trade out of its current financial difficulty. If however, the financial difficulty is not a short term problem then the overdrawn director’s loan account can simply steadily rise year on year. It may therefore be unsuitable for a Director to rely upon it as a process to delay payment of tax.

A rising overdrawn director’s loan account will often mean the cash flow problems are only temporarily relieved because HMRC does not permit a company to pay a Director by way of loans without there being tax consequences. 

Company Tax Implication To Sort Out Due To An Overdrawn Director’s Loan Account

The company tax implication of an overdrawn director’s loan account is that arising due to Section 455 of the Corporation Tax Act 2010

If a Director is drawing a salary then the company will pay PAYE and National Insurance every month. If a company has instead paid monies to a Director as an overdrawn director’s loan account then the tax implications do not crystalise until 9 months after the year end. Then the company will be liable to pay tax due to Section 455 of the Corporation Tax Act 2010. This is currently charged on the overdrawn balance at the year end at the rate of 33.75%. 

Unlike the payment of tax on a salary that is spread over the year Section 455 tax arises as a charge to be paid in one lump sum 9 months and one day after the year end. So unless a Director has been setting money aside it can result in a significant cash flow problem for the company. 

Personal Tax Implication To Sort Out Due To An Overdrawn Director’s Loan Account

The personal tax implication of an overdrawn director’s loan account is that arising due to Section 415 of the Income Tax (Trading and Other Income) Act 2005

The personal tax implication to sort out due to an overdrawn director’s loan account is if the Director is unable to repay the balance due to the company and it has to be written off then they will personally have an income tax charge due to Section 415 of the Income Tax (Trading and Other Income) Act 2005.

It might be possible to write off a portion of an overdrawn director’s loan account each year so the income tax payable does not lead to substantial liabilities for the higher rate of personal income tax. However, what if a Director is unable to personally pay this Section 415 tax? Well, whilst it may be possible to defer matters for some time (perhaps even years), if the company ultimately fails and goes into insolvent liquidation and if the liquidator has to write off the overdrawn director’s loan account, this can result in the accumulated overdrawn director’s loan account balances being written off in one tax period. If this arises it can mean a substantial personal tax bill for the Director and much of it could be payable at a higher rate of income tax which could even lead to their bankruptcy.

In order to avoid the pitfalls of not sorting out an overdrawn director’s loan account it appears that being aware of such matters and discussing them with your financial adviser could go a long way to avoid the sort of potentially unwelcome consequences of letting an overdrawn director’s loan account accumulate and potentially get out of control.