A director’s loan account is an account between the director of the company and the company in its own right. When a sole trader incorporates the assets of the sole trade, including the tangible fixed assets as well as intangible assets, such as goodwill (which is a valuation of the ‘trade’), are often transferred in to the company at net book value and the proprietor will be appointed as the company director. In most circumstances the company will not have the cash to pay the director for the trade and assets therefore it is common practice to credit the director’s loan account.
In the above the situation the director’s loan account is a credit balance that will be settled at some point in the future. The exact timing the loan account is cleared will vary from company to company, and the attitude of the director plays a significant part. Some directors will want the cash as soon as possible, therefore cash will be extracted from the new company as it earns it. Other directors will take a less aggressive stance and will leave the money in the company until it has become established and built up significant reserves.
The loan to the company can be treated as a commercial loan therefore the director can charge interest, although this is discretionary. Some directors will charge interest, whereas some won’t. Once again it will depend upon the attitude of the specific director.
The director’s loan account should always be in credit, i.e. the company owes the director. If the loan account becomes a debit balance, i.e. the director owing the company money this is effectively illegal under UK company law, however in reality it does happen and it happens frequently. When a director’s loan account becomes overdrawn the company y should start to charge interest on the loan at the authorised rate. Failure to charge interest means the director receives a beneficial loan and there are benefit in kind implications and additional national insurance will become payable, which will open up a whole can of worms for both the company and the individual.
If or when the director’s loan account becomes overdrawn the director should repay the loan as soon as possible, at least within nine months of the accounting period end. If the loan is repaid within nine months of the accounting period end there will be no corporation tax issues for the company. However, if the loan is not repaid within nine months of the accounting year end the company will have to pay section 419 tax on the outstanding amount. Section 419 tax is charged at 25% of the outstanding loan and is payable at the same time the corporation tax is due.
The Section 419 tax can be reclaimed from the tax man once the overdrawn loan account has been settled by the director, however it cannot be recovered until the next corporation tax return is filed, which may be many months in the future. Section 419 tax is an opportunity cost in that it is money in the tax man’s account generating money for him as opposed to money in the company’s account generating a return for the company.
In reality, a director’s loan account is often a moving feast and there will be times when the director will draw cash out of the company for personal use, which is fine provided the credit balance is sufficient to cover the drawings. In reality, directors of small companies often personally pay business expenses, leave their salary in the company and vote dividends but don’t draw the cash out of the company. In these circumstances the expenses paid by the director should be debited to the profit and loss account and the corresponding amount should be credited to the director’s loan account, which will increase the credit balance.
In small companies where the director personally pays the company’s expenses or doesn’t draw dividends or salary, but makes ad hoc drawings from the company the director’s loan account should be closely monitored to ensure the loan account remains in credit. If the loan account becomes a debit balance the director should repay the amount as soon as possible, although rather than waiting for this to happen monitoring the loan account will allow the director to inject more cash in to the company, hence increasing the credit balance, in times when it looks like the account may go overdrawn in the near future.