Director’s loan account risks and issues

A director's loan account is a running record of money flowing between a company and one of its directors, outside of salary, dividends, or legitimate expense reimbursements. It tracks amounts the director owes the company and amounts the company owes the director. In simple terms, if you as a director take money out of the company that is not salary or a declared dividend, that withdrawal is recorded as a loan from the company to you. Conversely, if you put personal money into the company, the company owes that back to you.

It is an extremely common feature of owner-managed companies and, when handled properly, is perfectly lawful. However, it is also one of the most frequent sources of trouble for directors of small and medium-sized companies, and the problems that can arise span company law, tax law, and insolvency law.

How it works in practice:

The account is simply a ledger entry in the company's books. Every time a director draws money from the company (other than through payroll or a properly declared dividend), the amount is debited to the director's loan account. Every time the director puts money in or repays, it is credited. At any point the account has either a credit balance (the company owes the director) or a debit balance (the director owes the company).

Tax consequences of an overdrawn account:

When the director owes the company money and the loan remains outstanding nine months and one day after the end of the company's accounting period, the company must pay a tax charge under section 455 of the Corporation Tax Act 2010. This is currently 33.75 per cent of the outstanding loan balance. The company gets this back when the loan is eventually repaid, but it is a real cash flow cost in the meantime.

In addition, if the loan exceeds ten thousand pounds at any point during the tax year and no interest is charged, or interest is charged below the official rate set by HMRC, the director is treated as receiving a benefit in kind. This must be reported on a P11D, and both income tax and Class 1A National Insurance contributions arise.

The bed and breakfasting trap:

Some directors try to repay the loan just before the section 455 deadline and then draw it back out again shortly afterwards. Parliament closed this down with anti-avoidance rules in sections 464A to 464C of the Corporation Tax Act 2010. If a loan of at least five thousand pounds is repaid and new loans or advances of at least five thousand pounds are made within 30 days, the repayment is matched against the new loan and the section 455 charge is not treated as having been avoided. There are further rules catching arrangements where the intention is to repay and redraw within a broader window.

Unlawful dividends and disguised remuneration:

Sometimes what is recorded as a director's loan is actually an informal dividend that was never properly declared or for which there were insufficient distributable reserves. This creates serious problems. An unlawful dividend can be recovered from the director under section 847 of the Companies Act 2006 if the director knew or had reasonable grounds to know that the distribution contravened the Act. Even if the director did not know, the company itself may have a claim. In insolvency, a liquidator will almost certainly pursue this.

There is also a risk that HMRC may characterise repeated or systematic drawings as disguised remuneration, triggering income tax and National Insurance as if the amounts were employment income, potentially under the disguised remuneration rules in Part 7A of the Income Tax (Earnings and Pensions) Act 2003.

Insolvency consequences:

This is where things become most dangerous. If the company enters insolvent liquidation or administration and the director's loan account is overdrawn, the liquidator or administrator will treat the balance as a debt owed to the company and will pursue the director personally for repayment. There is no discretion about this. The office holder has a duty to realise assets for creditors, and an overdrawn director's loan account is an asset of the company.

Directors sometimes assume the loan can be written off or set against future dividends or work done. Once the company is insolvent, these arguments almost always fail. The liquidator is not bound by any informal understanding between the director and the company, and any attempt to write off the loan close to insolvency may itself be challenged as a transaction at an undervalue under section 238 of the Insolvency Act 1986 or a preference under section 239.

If the director allowed the loan account to grow while the company was heading towards insolvency, this can also be evidence of wrongful trading under section 214 of the Insolvency Act 1986 or misfeasance under section 212. A liquidator may use the state of the director's loan account as part of a broader claim that the director failed to act in the interests of creditors.

Fiduciary duties:

Under sections 171 to 177 of the Companies Act 2006, directors owe duties to the company including the duty to act in the way most likely to promote the success of the company, to exercise independent judgement, and to avoid conflicts of interest. Drawing large sums on loan from the company without proper authorisation, without considering the company's cash flow needs, or while the company is in financial difficulty can amount to a breach of these duties. Where the company is insolvent or on the verge of insolvency, the duty shifts towards the interests of creditors under section 172(3).

Proper authorisation:

Loans to directors require compliance with section 197 of the Companies Act 2006. For a private company, a loan to a director must be approved by an ordinary resolution of the members, unless the aggregate amount does not exceed fifty thousand pounds (though this threshold does not override the tax and fiduciary issues). For a public company or a company associated with a public company, the rules are stricter. Failure to obtain proper approval makes the transaction voidable under section 213, and the director may be liable to account to the company for any gain and to indemnify the company for any loss.

Practical points to manage the risks:

1. Keep the director's loan account accurately and up to date at all times, reconciled at least monthly.

2. Ensure any loan to a director is properly authorised by shareholders in accordance with section 197.

3. Pay interest at or above the official rate to avoid benefit in kind charges.

4. Monitor the balance carefully in the run-up to the section 455 deadline and plan repayments or dividend declarations accordingly.

5. Never assume a loan can be informally offset against work done, future salary, or notional dividends. If a dividend is to be used to clear the loan, it must be properly declared with sufficient distributable reserves, supported by interim or full accounts.

6. If the company is in any financial difficulty, stop drawing on the loan account immediately and take advice. Increasing an overdrawn balance while the company slides towards insolvency is one of the most common causes of personal liability for directors.

7. Keep proper records of the purpose and authorisation of every drawing, so that if the account is ever scrutinised by HMRC or a liquidator, there is a clear trail.

In summary, a director's loan account is a useful and legitimate tool for managing money flows in an owner-managed company, but it sits at the intersection of company law, tax law, and insolvency law, and it requires careful management. The consequences of getting it wrong range from unexpected tax bills to personal liability running to the full balance of the account and potentially beyond.