Overdrawn director’s loan accounts
In challenging economic times it is not uncommon for directors, who hold shares in the company, to choose to draw funds from the business rather than to take a salary.
This is done on the basis that the “overdrawn loan account” (as it’s known) is then repaid at the end of the year when the dividends are declared.
All above board
Overdrawn director’s loan accounts are perfectly legal. One of the main advantages of following this strategy is the reduction in National Insurance contributions to be paid by both the company and the director in question.
Problems that may arise
There are, however, several significant pitfalls with this strategy which you should be aware of if you are thinking of going down this route:
- If the company doesn’t have sufficient profits or distributable reserves to declare a dividend at the end of the financial year, there will be an overdrawn director’s loan account sitting on the books; this will attract a S455 taxation liability payable by the company.
- If the company becomes insolvent and a liquidator is appointed before dividends can be legally declared to repay the loan account, the consequences are very serious. One of the liquidator’s duties is to review payments made to directors and shareholders in the period prior to the company’s insolvency. Unlike a salary paid through the PAYE system, the law states that an overdrawn loan account is repayable in full to the company.
- If dividends were declared in earlier years to clear a director’s overdrawn loan account but a liquidator later finds that the company had insufficient reserves to declare such dividends, the value of the ‘illegal’ dividends may have to be repaid to the company.
A balanced decision
If the business’s sustained solvency is in any doubt, you should consider very carefully whether the short-term savings in NI contributions are worth the potential claim by a liquidator – at a later point in time – for repayment of the earlier drawings.
It may prove wiser to take a salary through the PAYE system, even if this adds additional costs to the business, as at least you’ll know exactly where you stand without the uncertainty of possible future claims.