What directors need to know about overdrawn Director Loan Accounts

Being a director and shareholder of a company can be very rewarding and, importantly for many, financially beneficial. However, if a company becomes insolvent then it can sometimes become a costly affair for the director.

When we’re approached for advice, it occasionally emerges that the director has a debt to the company from an overdrawn Director Loan account (DLA). In some cases, the directors aren’t aware of what this means, how it occurred, or the possible implications.

In this blog I explain the importance of understanding how withdrawals from a company are treated and why it’s important to review this position if the company shows signs of insolvency or the directors predict trading issues on the horizon.

What is a DLA?

A DLA is an account in the company’s accounting records which details certain transactions between the director and the company. The account can be in credit or overdrawn, depending on whether the director has personally funded trading or withdrawn monies from the company.

If the account is in credit at the date of insolvency, then the director will be an unsecured creditor for the monies owed to them. However, if the account is overdrawn then this will be a potential asset which the Office Holder will be duty bound to investigate and attempt to recover for the benefit of creditors.

Wages, drawings and dividends

Monies paid to a director under an employment contract and which are reported through the company’s payroll scheme are wages/salary. Wages would not typically feature on a DLA unless the wages were unpaid, in which case they could be a credit on the DLA.

Monies withdrawn which are not wages, or repayment of business expenses, will be classified as drawings. It’s these amounts that will be added to a DLA which could leave it in an overdrawn position.

Where the director is also a shareholder, it’s common for them to take money out of the company as drawings rather than salary as part of tax planning. Whilst the regular drawings will create a temporary overdrawn DLA position, company profits can subsequently be used to declare and pay dividends to shareholders which can then be offset against the DLA.

How will I know if I have a DLA already?

• Accounting records: Check your accounting software for a director loan account ledger.
• Financial accounts: The DLA may be listed under creditors or debtors, depending on the status of the DLA.
• Ask your accountant.

Impact of insolvency

The impact of insolvency can be significant, as it’s likely to mean the company is no longer generating profits and any retained profits may have been eroded too. In these circumstances, the company wouldn’t be able to declare dividends which can be used to offset against the drawings already taken, leaving the director with an overdrawn DLA. If the company is then forced into an insolvent process, the director would be required to repay the balance of their DLA.

Directors often say to us, “But it was just part of my wage” or “The accountants told me to take money this way”.

It should be noted that it’s not suitable to reclassify prior drawings as salary ahead of an insolvency event. This would most certainly be considered as misconduct by the director and challenged. The misconduct could have further implications, such as disqualification.

It’s crucial for directors to be aware of the company finances and understand how their drawings compare with the level of projected profits. If there is any doubt, the director could look to protect their position by taking future payments as wages (so long as the salary wouldn’t be deemed excessive for the role performed). Whilst this can be more costly for the company overall, it may be necessary for the director to avoid exposing themselves to personal liability.

Alternatively, the director could stop drawing any funds from the company altogether.

Example

Mr Smith is the sole director and shareholder of a company.

Mr Smith works out that he needs £3,000 a month to meet his personal living costs. On advice of his accountant, Mr Smith draws a wage of £1,000 per month and the additional £2,000 is debited to his DLA. By the end of the company’s financial year the director’s DLA is overdrawn by £24,000.

Once the annual accounts are finalised, it transpires the company made £30,000 profit. These profits are subsequently declared and paid as a dividend to Mr Smith as the sole shareholder. Mr Smith would receive a credit to his DLA of £24,000 and a further payment of £6,000.

The director continues with the same level of drawings for the following financial year. Once the accounts are prepared at the end of that year it transpires that the company made a loss of £40,000, due to some bad debts and a downturn in trade. Accordingly, the company is not able to declare a dividend to shareholders.

The company trades for a further three months but, due to increased trading losses, mounting creditor pressure and severe cashflow problems, the director seeks advice from an Insolvency Practitioner. Mr Smith concludes that he has no option but to cease trading and place the company into liquidation.

At the date of insolvency, Mr Smith’s DLA was £30,000 overdrawn (15 x £2,000).

In this scenario, Mr Smith may have been able to reduce his exposure by increasing the level of his wage and reducing/stopping the non-salary drawings. The sooner that he could have done this the better.

Need help?

If you would like to discuss the implications of DLA, please get in touch with our Insolvency & Recovery team. Alternatively, call 0330 024 0888 or email enquiry@larking-gowen.co.uk.

Lee Green

Licensed Insolvency Practitioner