Directors be Vigilant! Talk to your Accountant to understand a Director’s Loan Account and your potential Liabilities

If your company is liquidated, overdrawn Directors’ Loan Accounts and Illegal Dividends can lead to Liquidators’ Claims and even Director Disqualification

In our experience, a Director’s Loan Account (DLA), and how and when one can be used, is a complex area and often not fully understood by directors, especially in the SME sector. To put it simply, a DLA must be repaid by the director(s), either by dividend or actual cash injection, within a set time period to avoid a big tax payment. However, if the company becomes insolvent and there are outstanding overdrawn DLAs, then the director(s) will be expected to repay them personally, with a Director Disqualification investigation also being a possibility.

In this article we look at the related areas of overdrawn Directors’ Loan Accounts and the payment of Illegal Dividends, and how talking to their accountant can help directors avoid overdrawn DLAs. Of course, if a company becomes insolvent and there is an overdrawn DLA, the sooner you talk to a Licensed Insolvency Practitioner the better.

Directors Loan Accounts – Talk to your accountant first

A Director’s Loan Account is used to record and document the transactions between the company and the director(s). If the director takes money out of the company, the Director’s Loan Account will be in debit and the director will owe the company money.

Taking out a director’s loan can give the director access to more money than they are currently receiving via salary and/or dividends and are typically used to cover short-term or one-off expenses, such as unexpected bills.

There is not normally an issue with borrowing money via a DLA providing it is repaid within nine months of the end of the company’s accounting period and the company remains solvent. If the overdrawn DLA is not repaid, then the corporation tax charge is a hefty 33.75% on the outstanding balance.

To recap – Directors’ Loan Accounts must be repaid and best practice is to have an accountant monitor a DLA to track the borrowing so that directors can stay on top of any required repayments to avoid the tax payment. Accountants will tell you that DLAs are admin-heavy and because they come with risks (such as the potential for heavy tax penalties mentioned above), they shouldn’t be used routinely, but rather kept in reserve as an emergency source of personal funds.

Overdrawn Directors Loan Accounts at Liquidation

We are seeing an increase in enquiries from struggling companies where overdrawn Directors’ Loan Accounts are an issue. Anecdotally, it is commonly accepted in the Insolvency profession that between 75% and 80% of business insolvency cases involve overdrawn director loan accounts.

An overdrawn Director’s Loan Account happens when there is a balance owed from the Director to the company at liquidation, and once a Liquidator is appointed, they are obliged to recover any such amount that is owed by the directors, which is treated as a debt that is owed to the company.

Such Liquidators’ Claims are usually paid personally by Directors, but if they do not have the funds to do so, then their personal assets could be at risk, with legal action being the ultimate weapon to gain recovery. When disputed, cases can and do end up in Court, and if the Director loses, they typically end up paying legal costs as well as the claim – sums which can be hugely expensive.

What about Illegal Dividends?

If the director does not have the available funds to settle an overdrawn DLA, they can consider declaring a dividend for the director, providing the company is making a profit, and the director is also a shareholder. Dividends are only payable from profits, and yet we regularly see Directors paying Dividends as insolvency approaches and even when insolvent, where profits are highly unlikely.

The rules as they stand stipulate that in the time-period leading up to insolvency and a Creditors’ Voluntary Liquidation, the focus switches away from Directors towards Creditors. So, declaring a dividend in the lead up to liquidation, as an attempt to cancel or reduce an overdrawn Director’s Loan Account, for example, is no solution at all.

Liquidators can, and do, seek to reclaim such Dividends from the Directors personally, because such Dividends are illegal. Financial recovery action is part of a Liquidator’s remit.

The aftermath of the pandemic and the current inflationary pressures and high energy costs are key drivers in the falling profits (and increasing corporate insolvencies) that are being seen right now. Falling profits are important in the arena of illegal dividends because sums that directors typically take out of the company to pay for non-business personal expenses are charged to the Director’s Loan Account. Then, in order to redress the resulting overdrawn position, a Dividend is declared to repay the sums due before the company’s Accounts are finalised. However, if the profits are not there to allow for the Dividend, then any such Dividend will be illegal and will be investigated at liquidation. Clearly, with many businesses suffering right now, it is likely we will see an increase in such investigations.

Under these circumstances, more directors are likely to face financial recovery action at liquidation.

What can directors do?

Antony Batty, Licensed Insolvency Practitioner, comments:

“As Insolvency Practitioners and recovery and turnaround specialists, our first aim is always to see if we can rescue distressed businesses. The earlier we are called in by businesses, or by their accountants, concerned about impending insolvency, the more we can do to help.”

Indeed, research by R3, the insolvency industry body shows that in more than 40% of cases where Insolvency Practitioners are instructed, liquidation is avoided, using processes such as Company Administrations and Company Voluntary Arrangements.

Antony Batty continues:

“Where liquidation is the only available option, it is vital that businesses and directors are well advised by their accountants and referred to us at an early stage, so that they do not fall into the traps of overdrawn directors’ loan accounts and paying illegal dividends that can end up with expensive, time consuming and stressful consequences, including personal repayment of DLAs and even Director Disqualification.”

If you are concerned about the financial position of your company and are facing insolvency, please contact us at one of our offices:

Also, K&W Recovery, trading as Antony Batty and Company, Thames Valley:

Our Insolvency Practitioners will take you through your options step by step and will advise you of the best one to take under the prevailing circumstances.