Overdrawn Director’s Loan Account: Definition, Interest, Problems & More
A director’s loan account (DLA) is a record of any money a director either borrows from or lends to the company, separate from salary, bonuses, or dividends.
The DLA is an essential part of company accounting, especially for small and medium-sized businesses. When operated correctly, it can help the company and its directors manage liquidity, cash flow, and short-term funding needs.
This guide delves into the potential financial, tax, and legal complications that can arise when a director’s loan account becomes overdrawn. We also provide some helpful advice on what you can do if you are a director struggling to repay your DLA.
What is an overdrawn director’s loan account?
An overdrawn director’s loan account occurs when the director has taken more money from the company than they have put into it. Essentially, it means the director owes the company money.
Often, directors take money from their company when business is going well, but when the business hits hard times, they struggle to repay these funds.
While it’s not illegal to have an overdrawn DLA, it can lead to significant tax consequences and penalties if not handled properly.
To avoid these repercussions, the balance of an overdrawn director’s loan account must be repaid within a specified period, usually nine months after the end of the company’s accounting period.
The benefits of a director’s loan account
- Short-term access to funds: A DLA allows directors to borrow money from the company when needed, providing quick access to funds for personal or emergency use. This can be a flexible way to manage liquidity without going through formal dividend declarations or salary adjustments.
- Support for business operations: As well as borrowing money, directors can use a DLA to loan money to the company to help with immediate cash flow issues and withdraw it when the business is in a better financial position.
- Tax planning: Directors can use DLAs strategically for tax planning. For example, withdrawing money as a loan rather than a salary or dividend may delay immediate tax liabilities.
- Interest benefits: If a DLA is set up correctly, the director may charge interest on loans made to the company. This can create an additional source of personal income, and the company may be able to deduct the interest payments as a business expense.
How does a director’s loan account become overdrawn?
Several factors can lead to a director’s loan account becoming overdrawn, including poor financial management, unforeseen financial needs, or company liquidity issues.
Common causes for an overdrawn directors loan account include:
- Mismanagement of funds: Many directors, especially in small businesses, do not always distinguish between personal and company funds. This can lead to using the company’s resources to cover personal expenses, resulting in an overdrawn account.
- Salary and dividend drawdown: Directors may decide to take part of their compensation as salary and the rest as dividends. However, dividends can only be declared when the company has sufficient profits. If a director takes an advance in the expectation of future profits, but these profits are not realised, the loan account can become overdrawn.
- Poor record-keeping: Inadequate bookkeeping practices can lead to an overdrawn director’s loan account. If transactions are not recorded correctly, directors may withdraw more funds than they are entitled to, often without realising it.
- Short-term loans to cover personal financial needs: Directors may take short-term loans from the company to cover personal financial obligations. If these loans are not repaid in time, they can lead to an overdrawn loan account.
- Cash flow management: In some cases, directors may use the company’s resources to manage personal cash flow problems. If this borrowing is not carefully monitored and repaid, it can accumulate into a significant liability.
Implications of an overdrawn director’s loan account on the company
HMRC takes an overdrawn director’s loan account very seriously. Specific tax implications arise when the loan is not repaid within a set time frame.
Section 455 tax charge on overdrawn DLAs
Under Section 455 of the Corporation Tax Act 2010, if a director’s loan is not repaid within nine months of the company’s year-end, the business must pay additional corporation tax at a rate of 33.75% (as of 2024) on the outstanding amount. This penalty aims to stop directors from using company’s funds as long-term personal loans.
Example of a Section 455 tax charge:
If a director owes £10,000 to the company and fails to repay it within the required timeframe, the company must pay an additional £3,375 in corporation tax. Once the company has repaid the loan, it can reclaim this tax, but it may take a significant amount of time for HMRC to process the repayment.
Other financial penalties
In addition to the Section 455 tax charge, an overdrawn DLA may lead to additional fines and penalties from HMRC.
For example:
- If the company fails to pay the Section 455 tax by the deadline, HMRC may impose interest on the unpaid tax. The interest continues to accumulate until the tax is fully paid, increasing the company’s financial burden.
- If the company does not accurately report the overdrawn DLA or misses filing deadlines related to this, it may incur fines or penalties.
Company insolvency
An overdrawn DLA means money that could be used to run the business is instead being used as a loan to the director.
If the amount owed is significant and the director cannot repay the loan, this can strain the company’s liquidity, making it difficult to pay creditors and suppliers or meet operational expenses. Over time, this cash flow shortage can result in company insolvency.
Did you know?
Overdrawn director’s loan accounts are thought to be involved in around 75% to 80% of business insolvency cases.
Four Implications of overdrawn DLAs on directors
An overdrawn director’s loan account is effectively an interest-free loan.
However, when a DLA becomes overdrawn, it can lead to significant personal and financial consequences, including:
- Interest on directors overdrawn loan account
A company may charge interest on loans not repaid within the agreed-upon timeframe. Interest demonstrates the loan is genuine and the director is paying for the privilege of borrowing money.
The interest charged should be in line with market rates or HMRC’s official interest rate (which is subject to change).Charging a market interest rate can help prevent HMRC from classifying the loan as a benefit-in-kind, which comes with additional tax liabilities.
- Director tax liabilities on overdrawn DLAs
If a director borrows money from the company at zero or low interest rates, or if the loan is written off, it may be classified as a benefit-in-kind and subject to National Insurance contributions and income tax. - Potential legal consequences
While an overdrawn DLA is not illegal, it can raise red flags with auditors, shareholders, and regulatory authorities. In some cases, directors may face accusations of misappropriation of funds or fraudulent trading, especially if they have a substantial unpaid loan and the company becomes insolvent. - Company insolvency and director’s liability
If a company enters liquidation while a director’s loan is overdrawn, the director becomes liable for repaying the debt. If the director is unable to repay the funds, this could lead to personal financial problems, including bankruptcy and director disqualification.
If a director continues to draw funds through the DLA while the company is facing financial difficulty, it could be seen as mismanagement or wrongful trading.
In cases of liquidation, directors may be held personally liable for worsening the company’s financial condition, especially if they withdrew funds that could have been used to pay creditors.
A company director was disqualified from being a director for six years after failing to keep adequate accounting records for after his company went into liquidation. The Insolvency Service was unable to determine whether the director had paid back an overdrawn DLA.
What happens if you can’t pay back a director’s loan?
- Financial penalties: If the loan isn’t repaid within nine months and one day after the company’s accounting period, the company will face a Section 455 tax charge. HMRC may impose additional penalties and interest, further increasing the financial burden on the company.
- Personal tax liabilities: If the loan is written off or forgiven, it becomes a benefit-in-kind and is treated as taxable income for the director. The company may also face additional National Insurance contributions.
- Loan treated as dividends or salary: In some cases, the company may decide to treat the unpaid loan as salary or dividends. This will incur income tax and National Insurance liabilities for the director. It’s essential the company has enough retained profits to declare dividends; otherwise, the transaction could be considered illegal.
- Increased salary payments: A director may choose to increase their salary or declare a bonus to offset the overdrawn balance. However, this option will lead to increased personal income tax and National Insurance contributions.
- Legal action: In severe cases, if the company or its shareholders believe the director is misusing company funds or acting irresponsibly, they may pursue legal action.
- Reputational damage: Having an overdrawn director’s loan account that cannot be repaid can damage the director’s reputation with shareholders, auditors, and other stakeholders, potentially affecting their standing in the company and future business ventures.
- Personal bankruptcy: If the director is personally unable to repay the loan and the company seeks recovery, the director may face bankruptcy proceedings. This could have severe long-term implications, including restrictions on running or being a director of other companies.
Five tips to avoid an overdrawn director’s loan account
Avoiding an overdrawn director’s loan account requires careful financial management and clear boundaries between company and personal finances. By adhering to best practices, directors can avoid potential tax issues, penalties, and legal complications.
- Keep personal and company finances separate
The most straightforward way to prevent an overdrawn DLA is to maintain a clear distinction between personal and company finances. Directors should avoid using the company bank account for personal expenses and ensure any transactions between the director and the company are well-documented. - Regularly review the director’s loan account
Directors should monitor their loan accounts regularly to ensure all loans are tracked and repaid in a timely manner. Regular reviews help prevent the account from becoming overdrawn inadvertently. Using professional bookkeeping services or software can make this process easier and more transparent. - Plan dividend and salary payments properly
Dividends should only be drawn from profits, and the company must ensure it has sufficient retained earnings before declaring them. Directors should avoid taking advances on dividends or salary without proper authorisation, which can lead to an overdrawn loan account. - Avoid large personal loans
If a director needs to borrow from the company, they should limit the loan amount and set clear repayment terms. Setting up a proper loan agreement can help avoid tax penalties and demonstrate the legitimacy of the loan to HMRC. - Seek professional advice
Tax laws and regulations surrounding director’s loan accounts can be complex. Directors should consult with a lawyer, accountant or tax advisor to ensure they understand the implications of borrowing from the company. This professional advice can help avoid potential tax penalties and ensure compliance with relevant laws.
Overdrawn director’s loan account - FAQs
Yes, a director can borrow money from their company, but it’s essential to properly document and repay the loan to avoid tax penalties.
As of September 2024, the current Section 455 tax rate in the UK is 33.75%.
No, sole traders and partnerships cannot use director’s loan accounts. DLAs are specific to limited companies, where the business is a separate legal entity from its directors.
For sole traders and partnerships, there is no legal separation between personal and business finances, so personal withdrawals are not considered loans.
Yes, once the loan is repaid, the company can reclaim the Section 455 tax charge from HMRC. However, the repayment may take some time to process.
Yes, the company can choose to write off the director’s loan. However, this is not always a favourable option because the written-off amount will be treated as income for the director, leading to personal tax liabilities. Additionally, the company may need to pay National Insurance on the written-off loan.
If your company goes into liquidation, you could be personally liable for repaying any outstanding loans to the company. If you are unable to repay the debt, you could face personal bankruptcy.
Contact our director defence lawyers today
If you are a company director facing financial distress or struggling with mounting debts, Summit Law can provide expert legal guidance to protect your interests.
With our 30 years’ experience, our exceptional director defence solicitors have unrivalled experience assisting directors against liquidator and creditor claims. These include overdrawn DLA’s alongside other claims such as wrongful trading, misfeasance, transactions at undervalue and preferential payments.
For your free consultation, contact our director defence solicitors today on 020 7467 3980 or complete the enquiry form on this page.