What is an Overdrawn Directors Loan Account?

What is an Overdrawn Directors Loan Account?

In many of our liquidation enquiries from directors of struggling companies, we find that this is a major problem, so what is an overdrawn directors loan account?

Well, usually the company was making profits and your accountants advised you to save tax by paying you, as directors, a small salary and then you take dividends from the reserves of profits made in the past and current years. So off you go taking money out of the business as instructed to save tax.

THEN something goes wrong!
Although the advice is generally sound from a tax reduction perspective, when a company is performing well; it’s when things go wrong that directors can end up with serious personal liability problems.
Technical Issues
Having an overdrawn director’s loan account is actually a breach of the Companies Act 1985. All accounts filed at Companies House should refer to any overdrawn Current accounts as loans to the director concerned. You must try to get these paid back or reversed in subsequent periods as the Revenue will tax you on a fairly penal rate if you do not.

If the company has no distributable reserves, it cannot pay dividends.

So if your company’s balance sheet starts a year with nil or negative reserves , then if you make no profit you MUST STOP taking dividends as soon as you are aware of this.

It is much better to pay yourselves through PAYE and pay the tax/NIC. If the company cannot afford to pay you GROSS then it is pretty much insolvent.

 

What can we do? Well options include:
Repay the debt you personally owe to the company.

Offset any loans the directors have made to the company (this is called set off).

Take your full salary but reduce the cash you take out of the business to gradually offset the account. So pay yourself £4,000 per month but take £1,000. Remember to pay tax on the £4,000!

Make a lot of profits in future periods to offset it!

Use a Company Voluntary Arrangement to restructure the debts of the company, whilst reversing current drawings through the PAYE Scheme.

Pay the liquidator when he asks for the money to be repaid that you “took from the company”. You may be able to “do a deal ” but it s likely the process will be costly!
What happens in liquidation if we have overdrawn current accounts?
In liquidation the liquidator can demand that directors repay their overdrawn directors loan account to the company for the benefit of the creditors. They can take legal action to make directors pay this or even potentially make you bankrupt.

So you could lose your house if your directors’ current account is overdrawn and not recovered.
Overdrawn directors loan account – Example Case Study
So here is an example case study / guide. If you need more detail call us now.

See if this rings any bells and then call us for help.

Mr Jones and Mr Smith set up a limited liability company based in London. It is a design and marketing company and they formed it in 2001.

Sales built quite quickly based upon the contacts in the marketing sector and the company grew to £1.2m sales. Their accountants told them that the company had made £80,000 net profit in year 1 and that this would be taxed for corporation tax purposes at roughly 20%.

So he advised them to leave their PAYE salaries at a lower level each month in year 2 and take dividends from the reserves and future profits.

This they did for a number of years and paid themselves quite well as the company was profitable each year.

Then that “something happened”.

Their biggest debtor went bust owing the company c£158,000. Silly to let that debtor take as much credit in my view, but their view was “after all the company was a well known big name customer and we never thought it would fail”. And it was good regular business for them so we understand why it got to be such a big debtor.

This led to a situation that was clearly not planned for. In 2006 the company had a bad trading year on top of the failed customer and so had to write the bad debt off. This made a huge loss for the year of £250,000. As a result the balance sheet then became negative (see insolvency test LINK and they saw the first flashes of a cashflow crisis looming.

So no further dividends could be taken AND the directors now had overdrawn directors’ current accounts to the tune of £70,000. With cashflow pressure mounting they came to KSA and said they needed restructure the company or close it.

This was our advice: consider the options, set out your objectives, look at the viability of the company and then make a decision to ACT. Call KSA in and we will set out the options in writing and in expert detail – that will help you decide.

Stop Options
If the company entered a formal terminal insolvency like administration, receivership, voluntary liquidation or compulsory liquidation, then the insolvency practitioner/liquidator could have demanded that the directors repay the £70,000 back to the company for the benefit of creditors.

This could have caused them personal financial hardship and with personal guarantees to the bank of over £200,000 the last thing they wanted to do was liquidation or administration. Indeed it was likely that personal Bankruptcy would follow.

Go Options
So we looked at the Go Options with them. (By the way we never charge for this detailed advice) and these included Trading Out, Trade Sale, CVA and or refinancing.

The key test is viability. We felt that one bad year and a huge bad debt did not equate to a bad business. Far from it this was a good business with dedicated directors and staff. So we said look at Go options and try and select the best option with our help.

We recommended that CVA would be the best solution and this was why.

The overdrawn directors current account liability would be “reversed”, in other words the payments would be treated as being net pay through the PAYE scheme. This of course generates a larger PAYE and NIC liability. But using the CVA the debt would be bound by the process. Along with reduction in people and managers (the lost contract meant that they had too many people) the company was forecasting a modest profit at best or just below break-even at worst.

The benefits for creditors were that they got a deal paying 55% of their old debt back over 5 years and kept their customer.
The benefits for the company were a downsized business, lower costs; long term survival, no lost contracts and we removed cashflow pressures whilst keeping the bank happy.
The benefits for the directors were that they avoided personal liability, avoided the failure, avoided bank personal guarantees being called up and also avoided the £70,000 debt to the company.
Plus as owners of the company they have long term employment and a valuable future business.
A great deal all round and guess what? The reversed tax was included in the CVA vote and HMRC supported the deal.
So if you or your directors have an overdrawn current account and a company that is under real pressure then call us on 0845 519 4930. As the above case study shows we can save your business and help you as directors.

 

We’ll give you free, high quality advice; please call 0800 9700 539 now.