It is established practise in small and medium size companies for owner directors to withdraw sums from the business ‘in lieu of salary’ and then, at the year end, to declare a dividend to clear to nil any balance on the Directors’ loan account. Provided the loan balance is cleared within 9 months of the accounting period this can be a tax efficient method of extracting funds.
But, what happens when the business ceases to be as profitable as the Director expects or worse the company can no longer trade?
Unless the company has sufficient reserves to be able to declare a dividend to clear the debt, unlikely if the company is no longer as profitable, the loan to the director will likely remain on the balance sheet more than 9 months from the year end thereby triggering a tax charge equal to 25% of the loan left outstanding at this point in time and just when cash is probably drying up. This charge is repayable to the company but only 9 months after the year in which the loan is either reduced, in which case only some of the charge is repaid, or the loan is cleared in full.
In a worse position are those companies facing insolvency. Directors have no entitlement to monies drawn out of the business unless extracted by formal salary or legal dividend. This means that a substantial debt may have been built up by a director and which is now due to be paid back to the company at a time when that Director is likely to be having their own cash flow difficulties. In an administration or liquidation the appointed representative may seek to pursue Directors for the repayment of the outstanding debt.
So what does this mean for me?
Foremost, if you are an owner/director extracting funds via a loan account it is vital you monitor carefully the profitability of your company a regular intervals to ensure its is generating sufficient distributable profits to declare the required dividend at the year end. If there is any doubt, reduce the level of drawings.
Secondly, if you need to draw an income from the business consider switching to formal remuneration such as drawing a wage/salary. There are tax consequences to paying a director a salary but provided the level is reasonable and the Director fulfils their fiduciary duty to act on the best interest of the company, salary payments should not be repayable should the business cease.
If you have any queries related to Directors’ Loans, profit extraction, or insolvency please do not hesitate to contact us.