Director’s Loan Account

There are three common misconceptions to put right before we dive in. Understanding these points will make learning about Director loan accounts (DLA) easier.

  1. A company Director does not receive dividends. Shareholders receive dividends. Individuals can, of course, be both but, do not assume that is automatically the case.
  2. Dividends are a distribution of profits. They can normally only be recognised if there are distributable reserves.
  3. The accounting entry recording a dividend does not necessarily have to be a cash event in itself.

What is a Director's Loan Account?

The purpose of a Director's loan account (DLA) is to act as a record of transactions between the Director and company.

The balances of each director account should be disclosed at the accounting period end as they are material by nature, regardless of value.

DLAs can only be used by companies that have Directors. A sole trader or any form of a partnership will not have DLA balances in their annual accounts. Only a private limited company (Ltd) or a publically limited company (Plc) will do so.

It's worth noting there are companies limited by guarantee rather than share capital. Charities are examples of a legal entity limited by guarantee rather than share capital but they are outside of the scope of this guide.

It isn't best practice to do so, but, in many instances, Directors will have personal expenses paid through the company bank account or a company credit card. The DLA is the accounting record for such transactions.

The Director can also incur business expenses out of their personal funds. If expense repayment is not made by the company, the value will be included in the DLA, offsetting or partially offsetting any liability.

Salary payments (via payroll) and dividends do not get recorded in the DLA.

As a Director you will be in one of the following three positions:

  • The business owes you money
  • You owe the business money
  • The balance is zero because there have been no transactions, or the value of inflows is equal to the value of outflows.

Overdrawn Directors Loan

If the Director has an outstanding balance to the business, the business recognises an asset. As an individual without any protection from the veil of incorporation, you owe the company money. You will also potentially owe any secured and unsecured creditors who have a claim over the legal entity.

From a business debt perspective, there are two things to consider with overdrawn loan accounts:

  1. The perception the lender will have regarding the overdrawn loan of the Director.
  2. The impact recovery could have on the overdrawn Director as an individual.

The Lenders Point of View

They will see you as having skin-in-the-game because the lender has the option to pursue you as an individual if there is financial difficulty and the loan defaults. Even if you don't have a personal guarantee, you will still be a debtor to the company and be on the hook to the lender and potentially other company creditors for the unpaid balance.

There are simple mechanisms that can reverse or zero the DLA balance. The Director should be aware that all are obvious. If they are relying on it to get off the hook, then they are in a pretty desperate place and unlikely to succeed.

The lender may include loan covenants that restrict the Director's ability to increase the overdrawn loan balance. They may also limit mechanisms for DLA reduction.

With good planning and proactive management, DLA issues can be avoided.

Quasi Salary

The lender may be interested in the substance of transactions in the director loan account.

Are there cash withdrawals similar in nature to a salary/wage?

If there is a recurring amount paid each month, it opens the question over a quasi salary and tax implications for both the Director and business. There will also potentially be a tax charge around the use of subcontractors/employees.

If the lender treats the payments as a quasi salary it will negatively impact your application. The lender may well take the below point of view:

  • The payments are balance-sheet-to-balance-sheet transactions, meaning there has been no recorded impact on the P/L.
  • If the substance of the transactions is a salary, profit will be overstated by the gross expense. There may also be issues with income tax, national insurance, and corporation tax (indirectly) as the payments have not been via the company payroll and not included in the P/L.
  • Remember the gross expense includes class 1A national insurance contributions, employers' pension contributions, and the employee's taxes.

The values involved and the impact their representation has on the financial statements is what's important here.

While serving on the credit committee of a non-bank business lender, I refused several businesses funding opportunities because of scenarios like the above.

Quasi dividend

The lender may test the assumption that the transactions are a quasi dividend or an illegal dividend.

From the lender's perspective, the risk is that business debt will be used to support the owners' lifestyle rather than for a business reason. Of course, the owner would also need to be a Director for the balance to appear in a Director's loan account.

If the business is:

  • profitable
  • Cash generative enough to support the payments
  • Has sufficient security in place
  • It appears the loan can be paid within the term and
  • The owner has made clear the intention is to make such payments

The lender may well be happy to agree to fund. Presented honestly and openly this scenario can make for a good quality loan.

The scenario a Lender will not like is one in which:

  • There is a history of spare/excess cash being taken out of the business, leaving little or no cash reserves.
  • A lack of or reducing loan security.
  • A retained loss- as a dividend can only be from retained profit.
  • Signs the business is failing- remember poor cash flow can be an indication this is the case.

In this situation, the lender may refuse your application. From their perspective, it will look like a drowning man grasping at a straw. No Lender wants to be the last firm lending to a business.

Director's Loan Account and Tax

This section intends to highlight areas for consideration. It does not amount to tax advice or a guide on tax rules. You should seek professional advice from a tax specialist if you have an issue or concern with any of the topics raised.

  • Tax avoidance
  • Class 1 National insurance underpayment
  • Corporation tax penalty
  • Misuse of a company asset
  • Income tax implications over correctly reporting personal income
  • Whether there should be tax payable on director's loans
  • Correct use of the official rate
  • Whether the balance is an interest-free loan or not
  • Classification and reporting of taxable benefits
  • Reporting of DLAs (see S455)
  • Reporting issues for the Directors' personal tax return
  • Even legal action

Director Loan Account TakeAways

DLA transactions are material by nature regardless of the value. For this reason, they will always attract the attention of Lenders and Auditors.

Directors are also always considered related parties, so any transactions must be disclosed and should be at arms-length.