Navigating Directors's Loans: Key Information and Insights

As a company director, what do you do when you need money as soon as possible but are struggling to get a loan from the bank? While the first thing you might consider getting a dividend from your company, this may not be possible if your company is not profitable. In those circumstances, you might consider a director’s loan, which is money taken out from your company’s accounts that are not used for salary, dividends, or expenses. If you want to take out a director’s loan, you will need to understand the risks and common legal issues arising from them.  

What is a director’s loan?

‘Director’s loan’ refers to a loan between a director of a company and the company. This loan arrangement can take two forms depending on whether the director or company is the party lending the money.

Firstly, a director’s loan can refer to an arrangement whereby a company lends money to one of its directors. In this scenario, the director becomes a debtor (somebody who owes money) of the company and would therefore be obligated to pay back the money borrowed from the company.

For it to be considered a director’s loan, the money conveyed from the company to the director cannot be classifiable as a salary, dividend, or another legitimate expense repayment. Furthermore, the money conveyed should not be classifiable as the repayment of monies previously lent to the company by the director.  

Secondly, a director’s loan can also refer to an arrangement where a director lends money to the company. In this scenario, the director becomes a creditor (somebody who is owed money) of the company. The company is the debtor and is obligated to repay the money borrowed from the director.

Secondly, a director’s loan can also refer to an arrangement where a director lends money to the company. In this scenario, the director becomes a creditor (somebody who is owed money) of the company. The company, a separate legal entity, is the debtor and is obligated to repay the loan money borrowed to the director (e.g. from company profits). 

When and why might I take out a director’s loan?

Why you might take out a director’s loan depends on who the lender is – the director or company.

Loans from a director to a company are usually done to help with start-up costs or to help the company deal with cash-flow problems to ensure that company activities can go on smoothly without incurring a lengthy process. 

Loans from a company to a director are usually made to cover large but short-term expenses. They tend to be unexpected and consist of one-off expenses. An example of this is when there is a sudden need by a director to pay for water restoration services.

Director’s loans, where the company is the lender, give the director access to more money than otherwise obtainable via salary or dividends. Directors’ loans however are not used routinely by directors and should only be used in emergencies where personal funds are insufficient.

Legal issues to consider when making/taking a director’s loan:

Every director and company should familiarize themselves with potential issues, obligations, and legal processes that surface when making/taking a director’s loan.

1. Compliance with director’s duties  

Directors owe statutory duties to their companies. Directors must therefore make sure that they do not act in breach of these duties when taking/making a director’s loan. The duties must be prioritised during every loan transaction.

Crucially, if the company is borrowing under a director’s loan, the directors of the borrowing company must ensure that the loan will promote the success of the company and not any other reason.

If a company is borrowing money under a director’s loan from one of its directors, this would constitute a conflict of interest for the director. To ensure compliance with director duties, the director must disclose this interest to the other directors before entering into the transaction. This can be done through a simple letter to the board of directors of the company.

We have created free template letters of disclosure for notifying the board of directors of a conflict of interest for you to use. You can find it here: https://docpro.com/doc164/disclosure-of-interest-director-s-loan.

2. Due Diligence

Like other loans, for director’s loans, the lender (be that the director or company) might conduct due diligence on the other party.

Due diligence, in the context of a loan, is a process where a lender evaluates whether the borrower will be able to repay the loan following an agreed schedule. Due diligence often involves an analysis of the financial position and assets of the borrower.

In the case of director’s loans, whether due diligence is conducted with any vigour depends on the company at hand.

If the borrower is the sole director and the shareholder of the company, due diligence will likely be minimal, if existent at all.

If the borrower is one of many directors in a large organisation, heavy due diligence may be required.

In any case, if the lender is a director and elects to conduct due diligence, the director should consider whether the borrower has the authority to borrow.

The activities of every company are restricted by its articles of association. The articles of association of a company may specify something to the effect that the company cannot borrow sums over a particular amount or cannot over a particular amount unless certain approvals are obtained.

In such a case, the director (the lender) should make sure they get proof from the company that approval has been obtained; otherwise, the director runs the risk that the loan is not binding on the company and will struggle for repayment. 

3. Obtaining security for the loan  

Whether the lender needs security for the loan is a business decision to be taken by the lender himself.

If the director is the lender under a director’s loan and is to obtain security over assets of the company, this may constitute a substantial property transaction.

The director, to ensure his/her security interest is actualised, should obtain shareholder approval for the transaction.

4. A loan agreement should be recorded in writing

The director’s loan should be recorded in writing and then be signed and executed by both parties. The actual loan facility should be signed by the company and director.

Despite this being a seemingly obvious step, small companies often fail to ensure that their agreements are in writing and signed by both parties.

We created a free template director's loan agreement you can use for this purpose here. 

What is a director’s loan account?

A director’s loan account is an account included in the balance sheet of a company. A director’s loan account is a record of all money lent by the director to the company and all money lent by the company to the director. Put simply, it is a record of the transactions between the director and the company.

At any given moment, the director’s loan account can either be ‘in-credit’, ‘overdrawn’, or 'zero'.

A director’s loan account is ‘in-credit’ if the company is borrowing more from the director than the director is borrowing from the company.

It is ‘overdrawn’ when the director is borrowing more from the company than the director is lending to the company.

It is zero when neither party owes the other any sum of money. This might be because both parties have borrowed and repaid identical amounts to each other.

At the end of the company’s financial year, the director will either owe the company money, the company will owe the director money, or nothing will be owed by either party. Accordingly, it will be shown as an asset or liability on the balance sheet of the company.

What should a director’s loan account include?

Items that should be included or should contribute to a director’s loan account include:

• Cash withdrawals made from the company as a director

• Personal expenses paid for using the company money

Business expenses are those that are incurred by the director under fulfilling their duties as a director. Other expenses will be considered personal expenses.

It is important to make sure that you have evidence proving whether the expense is a business or personal one. This is especially important when the inland revenue government department inspects your account.

How much can be borrowed in a director’s loan?

There is no cap on the amount that can be borrowed through a director’s loan by either the company or the director. This means a director/company can borrow as much as they want.

However, just because it is possible to borrow a lot does not mean that should happen. The director should consider the financial position of the company and should keep in mind the duties they owe as directors to their companies.

What is the interest in a director’s loan?

It is up to the director and the company to determine what interest rate it charges on a director’s loan.

When should a director repay a loan from a company?

In many jurisdictions, tax penalties apply, incentivising directors to repay their loans by a certain date.

Different jurisdictions have varying rules on the taxation of director’s loans. We are unable to cover all the different regimes in different common law jurisdictions, so we advise you to check what the rules are on your own.

To give you an example of a ‘tax penalty’ that incentivises a director to repay their loans by a certain date, we will focus on England & Wales laws.

In England & Wales, whether tax is owed depends on when the director repays the loan to the company. If the director repays the loan within the same financial year as he takes out the loan, no tax is owed. If the director settles the loan within nine months and one day of the company’s financial year-end, still, there is no tax.

If the director has paid part of the loan within nine months and one day of the company’s financial year-end, the company owes tax on the outstanding balance remaining. This amount will be taxed at a rate of 32.5%. This will be in addition to any corporate tax the company is liable for.

If the director settles the loan after nine months and one day of the company’s financial year-end, a tax of 32.5% will be payable on the loan amount.

The sum of tax paid at 32.5% can be reclaimed, but only after the full loan has been repaid to the company. Furthermore, it can only be reclaimed 9 months and 1 day after the end of the financial year in which you repaid all the loans to the company. To illustrate these rules, take the following example:

Jack borrows £20,000 on 12^th June 2020 and his company’s financial year-end is 31^st September 2020. Jack will have until 31^st July 2021 to repay the loan. If Jack does not pay by 31^st July 2021, the company has to pay 32.5% of £20,000 as a tax which is £6500.

Jack makes full repayment on 21^st September 2021. He will only be able to reclaim the tax – the £6500 – on 22^nd June 2021.

To avoid this hefty tax, you should repay your loan within 9 months and 1 day after the end of the financial year of your company.

Please note that this is a general summary of the position under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may wish to consult your lawyer.