What is a Director's Loan and What You Need to Know

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Date published: 8 Jan 2021
by DocPro Legal
Last Update: 17 Feb 2021

Everything in your life is going smoothly, until one week a pipe bursts and floods your entire house. The damage is considerable, and you need money from somewhere, fast. You know that you will struggle to get money from a bank and so settle to take money from your company.

 

One solution would be to give yourself a dividend from your company. You quickly realise, however, that this is not possible because your company is not profitable yet. Another solution would be to give yourself a director’s loan.

 

This article will explain everything you need to know about director’s loans, including an explanation of the common legal issues arising from them.  

 

What is a director’s loan?

The term ‘director’s loan’ refers to a loan between a director of a company and the company itself. 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 is obligated to pay back the money borrowed to the company.

 

To be considered a director’s loan, this money conveyed from the company to the director should not 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.  

 

A director’s loan also refers to an arrangement whereby a director lends money to a 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 to the director.

 

 

When and why might a director’s loan be made?

The common reasons for making a director’s loan vary depending upon who the lender is: the director or company.

 

Loans from a director to a company are usually made to help with start-up costs or to help the company deal with cash-flow problems.

 

Loans from a company to a director are usually made to cover large, short-term expenses – such as, from our example in the introduction, to meet a sudden need by a director to pay for water restoration services.

 

Director’s loans, where the company is lender, gives the director access to more money than otherwise obtainable via salary or dividends. They are generally not used routinely by directors and are only resorted to in emergencies.

 

Things to consider from a legal perspective when making/taking a director’s loan:

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

 

1) Compliance with director’s duties  

Directors owe duties, imposed by statute, to their companies. Directors must make sure that they do not act in breach of these duties when taking/making a director’s loan. These duties must be borne in mind throughout any such loan transaction.

 

Importantly, if the company is borrowing under a director’s loan, from the director the directors of the borrowing company must ensure that the loan will promote the success of the company and must not approve the loan for any other reasons. 

 

If a company is borrowing money, under a director’s loan, from one of its directors, the director will have a conflict of interest. The director, to ensure compliance with their director’s duties, should 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.

 

DocPro has free template letters of disclosure to notify the board of directors of a company about such a conflict of interest. You can find it through the following link: https://docpro.com/doc164/disclosure-of-interest-director-s-loan

 

 

2) Due Diligence

As with other loans, in the case of a director’s loan, the lender (be that the director or company) may conduct due diligence on the other party.

 

Due diligence, in the context of a loan, is a process whereby a lender evaluates whether the borrower will be able to repay the loan in accordance with 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 actually conducted with any vigour is dependent on the company at issue.

 

If the borrower is also the sole director and shareholder of the company, due diligence will likely be minimal if not non-existent.

 

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

 

In any case, if the lender is a director and elects to conduct due diligence, the director should make sure to 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 full stop or cannot borrow sums over a particular amount unless particular approvals are obtained.

 

In such a case, the director (the lender) should make sure they get proof from the company that such approvals have been obtained. Otherwise, the director runs the risk that the loan is not binding on the company and may 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.

 

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 such a transaction.

 

4) A loan agreement should be recorded in writing

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

 

Despite this seeming an obvious step, small companies often fail to make sure their agreements are in writing and signed by both parties.

 

DocPro has free template director's loan agreement which you can use for this purpose. You can find this template through the following link: https://docpro.com/document-form-select/Bilateral%20Standard%20Loan%20Market%20https://docpro.com/doc2058/directors-or-shareholder-loan-agreement-neutralDocument

 

 

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. In other words, it is a record of the transactions between the director and the company.

 

At any one moment in time, the director’s loan account will 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 fully repaid identical amounts from 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, this account will be shown as an asset or liability on the balance sheet of the company.

 

What should a director’s loan account include?

Items which should be included, or which 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

 

Generally speaking, business expenses are those that are incurred by the director pursuant to fulfilling their duties as a director. Other expenses will be considered personal expenses.

 

It is important to make sure that you have evidence proving the expense is a business one or personal. This is often important when the inland revenue government department inspect your accounts.

 

 

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 director. This means a director/company can borrow as much as they want, from the other.

 

However, especially if the director is the borrower, just because it is possible to borrow a lot does not mean they should. 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 different rules pertaining to the taxation of director’s loans. It is outside of the scope of this article to cover all the different regimes in different common law jurisdictions.

 

However, to give you an example of such a ‘tax penalty’ incentivising director to repay their loans by a certain date, we will focus on England & Wales.

 

In England & Wales, whether tax is owed on the loan depends on when the director repays the loan to the company.

 

If the director repays the loan within the same financial year as he took out the loan, no tax is owed on it.

 

If the director settles the loan within nine-months and one day of the company’s financial year-end, no tax is due on it.

 

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 to be paid by the director. This amount will be taxed at a rate of 32.5%. This will be in addition to any corporate tax the company will be 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, it can only be reclaimed once 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 loan to the company.

 

To illustrate these rules, take the following example:

 

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

 

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

 

To avoid this heavy tax, it is advisable that you 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.

 

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DocPro Legal

DocPro Legal is a team of legal professionals with a passion for making quality documents and legal contract templates widely available to the public through cutting edge technology. Our lawyers are qualified in numerous common law jurisdictions including the United Kingdom, Australia, New Zealand, India, Singapore and Hong Kong. We have experience in major law firms and international banks with expertise in business, commercial, finance, banking, litigation, family, succession and company laws.

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