Contractors, writing off your director’s loan is easier said than done

Director’s loan accounts and overdrawn director’s loan accounts aren’t straightforward at the best of times and with the cost-of-living crisis hardly letting up, it seems a refresher might be in order, writes Gareth Wilcox of Opus Business Advisory Group.

What is a director’s or participator’s loan?

Stripping back to basics, since a limited company is a separate legal entity to the directors and/or shareholders who control and own it, any funds paid in the absence of a payment obligation (e.g. salary, dividend or invoice payment) between the parties, represents a movement on a loan account.

The shorthand ‘DLA’ is often used to describe a Director’s Loan Account, i.e. specifically an amount owed to a company’s director. But at the top, I reference to a ‘participator’s loan’.

A participator is any person having a share or interest in the capital or income of the company, i.e. a shareholder. So participator loans are those owing to shareholders.

In the context of contractor limited companies (Personal Service Companies), clearly directors and participators will usually be the same person or people.

Why or when may a director’s loan arise?

As stated above, if money is paid to a director in the absence of a payment obligation, a loan account will arise. If you draw funds as a director of your limited company to pay a personal debt, such as a personal tax bill or mortgage payment, you would owe those funds at the point they were drawn.

Often in the case of PSCs, contractors will draw a low salary so they can maximise tax allowances, with the balance of the funds they require for living expenses being drawn by way of dividends.

Some contractors will do this on a monthly basis keeping personal and business funds separate. But we often see other PSCs with funds drawn on a more ‘ad hoc’ basis -- as needs arise.

Whichever of the above approaches are followed, provided there are sufficient reserves in a company for a dividend to be declared, a contractor (and/or their account) will deal with any loans which arise in this way, by declaring a dividend to ‘clear down’ any loan accounts.

A problem, however, arises if there are insufficient profit reserves to enable a dividend to be declared, since the obligation to repay the loan will remain in place.

What are my options if profit reserves are insufficient when a loan is outstanding?

Clearly the first option is to repay the loan by introducing cash back into the company. If this is possible and affordable, it is by far the simplest way of dealing with the situation.

In practice, however, this is not always a viable solution.

Can I write off a director’s loan?

While this may appear to be an attractive proposition, it is not likely to be appropriate in the majority of cases where a dividend cannot be declared.

Firstly, an individual would be potentially liable to pay personal tax on the amount of the loan written-off, since ordinarily such amounts would be considered taxable income which would need to be declared on a self-assessment tax return.

Additionally, if the write-off is being considered since there are not sufficient profits to pay a dividend, it follows that the balance sheet is likely to be in an insolvent position, therefore there is risk that the company may be placed into insolvent liquidation.

If this occurs, a liquidator is likely to challenge the write-off as a transaction at undervalue, or breach of the director’s fiduciary duty, with the result being that the write-off would be reversed and debt reinstated.

What if a loan is left unpaid?

A loan to a participator/director which is not repaid within nine months and one day of the end a corporation tax year will attract s.455 tax. Since April 6th 2022, this has been charged at a rate of 33.75% of the loan outstanding, so can result in a substantial tax liability falling on the company.

The good news is that once the loan is repaid, any s.455 tax paid on it is capable of being recovered, but not until nine months and one day after the end of the corporation tax period in which it was paid.

Final thought

As you will note from the above, director’s loans can lead to a number of complications. If you are concerned regarding your position, you should take professional advice at the earliest opportunity.