To understand overdrawn director loan accounts, we first need to cover why they exist.
Background
The situation arises most regularly in owner managed businesses where the business owner has been advised that the best way to minimise the tax burden is to draw a minimum salary (£7,020 in 2011/12), and take any further amounts due in dividends.
To declare a dividend, one of the requirements of the Companies Act is that the company has sufficient “reserves” to do so.
“Reserves” in a small business can be defined in one of two ways:
The mistake that business owners often make is to forget that both calculations require a calculation of the corporation tax liability that has accrued since the last year end.
Thus the business owner will draw from the business funds that should actually be retained to pay the corporation tax liability. (This can be the case with any liability for which an invoice has not been received, but corporation tax is the most common one in an owner managed business.)
The result is that there are insufficient reserves in the company to declare the dividends needed to cover the drawings made.
The extent to which drawings exceed reserves must therefore be accounted for as a loan to the business owner. These loans are often described as overdrawn director loan accounts.
What the law says
Tax legislation states that for any loan to a business owner to be legal it must incur interest at a commercial rate (4% is current rate approved by HMRC).
In addition, the legislation states that if the loan is not repaid with 12 months of the year end, then the corporation tax liability for the year will increase by 25% of the loan outstanding. This additional corporation tax payment is itself a loan, repayable by HMRC to the company 9 months after the end of the tax year in which the underlying loan to the director is repaid.
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