Exploring Director’s Loans
The funny thing about director’s loans? Most times business owners don’t even know they are creating one. Many of those are simply the owner forgetting about tax and super obligations and so on. As a result, they raid the coffers like Jack Sparrow on steroids! That usually ends badly. Or at the very least with very unpredictable results. It’s always unpleasant.
A little tax planning (or even basic budgeting) goes a long way. However, business owners can get a bit arrogant here and decide that, not only are they experts in their industry, but yes, they are experts in accountancy too. Kind of if you have a really good plumber – next time you are heavily constipated you decide to go to him instead of your local GP. No one is good at everything. So, please get your budgeting and tax planning in order – unless you want the ATO to rock up with a plunger!
Then, again – as usual, what do I know? About your circumstances? Well, it could much worse than what I am about to describe down here. Or not. As usual, I strongly recommend not following any advice you stumble across online, including mine. It is generic at best. At worst, implementing this without consulting an accounting could damage your business irrevocably. So, please consult a tax agent before doing and deciding anything with your tax matters (even if you have read my blog posts 5000 times).
As a company director, you may find yourself considering a director’s loan, also known as a shareholder loan, in situations where you require urgent funds but face challenges in obtaining a bank loan. Perhaps you’ve contemplated taking a dividend from your company, but this might not be feasible if your company is currently not profitable. In such circumstances, a director’s loan becomes an option. This entails withdrawing money from your company’s accounts that is not designated for salaries, dividends, or operational expenses. However, it’s crucial to recognize that this course of action comes with inherent risks and legal implications that demand your attention.
Understanding Director’s Loans
A director’s loan can take two forms:
- When the director borrows money from the company, which is expected to be repaid at a later date.
- When the director lends money to the company, and the company assumes the liability for repayment. This typically occurs when additional funds are required for business startup or to maintain operations during periods of cashflow challenges. In this scenario, the company becomes the debtor, and it is legally responsible for repaying the director, who becomes a creditor in this arrangement.
When and How to Utilize a Director’s Loan
Director’s loans are not a financial tool to be employed routinely. They should be reserved for emergency situations when personal funds are insufficient to address pressing needs.
In cases where a company lends money to a director, these loans are typically directed toward substantial, short-term expenses directly related to business operations rather than covering personal bills or personal tax obligations. These expenses often arise unexpectedly, such as the need to finance water restoration services.
When the company serves as the lender, it grants the director access to a more substantial amount of funds than what is typically obtainable through regular salary or dividends. However, it is essential to note that a director’s loan should never be used as a means to supplement wages. If you are unable to afford withholding or income tax on wages, a director’s loan is not a suitable solution.
How Does a Director’s Loan Function?
First and foremost, shareholder approval is required for a director’s loan. The exception is when your business is structured as a sole trader, in which case a written approval record suffices.
Additionally, it’s crucial to establish the loan correctly, including having an active loan agreement in place before the company’s annual income is reported. The loan agreement should encompass:
– Identification of the parties involved (the company and the director).
– Key terms and conditions of the loan, including the loan amount, repayment specifics, and applicable interest rate (which contributes to the company’s assessable income).
– Signatures of the parties (the company and the director).
– The date of the agreement.
Director’s Loan Repayment and Taxation
Whether the loan is disbursed as a lump sum or in multiple installments, its classification as a loan means it falls under Division 7A of the Income Tax Assessment Act 1936. Consequently, the borrower generally does not incur tax liability on the loan amount.
Minimum annual repayments on director’s loans are governed by Division 7A. If the loan is improperly structured (e.g., lacking a loan agreement) or the minimum annual repayment requirement is not met by June 30, the outstanding amount becomes a dividend in the same financial year under Division 7A. This implies that the borrower may be subject to taxation on the entire loan amount.
Director’s Loan Best Practices
Unfortunately, most director’s loans result from unforeseen cash flow issues rather than careful planning. Here are some indicators that suggest a director should think twice about borrowing from their company:
– The company possesses surplus cash beyond its standard operational requirements (i.e., funds not urgently needed).
– The loan represents a small fraction of the total company assets (e.g., less than 10%).
– A compliant loan agreement, provided by a tax accountant, is in place.
– There is a clear repayment plan, including associated interest charges, within the specified timeframe, without necessitating additional borrowing from the company.
– The loan is used for personal lifestyle expenses.
– The loan impairs the company’s ability to comfortably manage its operational cash needs.
– Borrowing is driven by insufficient wages, often because the company cannot cover withholding tax and superannuation for a wage increase.
– The loan is sought to settle personal tax obligations.
– Repayment is not feasible or there is no intention to repay the loan.
All in all, this is what you have to pre-emptively think of, before blowing up the bank account to the smithereens.
When considering a director’s loan, meticulous record-keeping of all amounts and dates is essential. Written approval confirmation is also crucial. Both the lender and borrower should be documented in the written record, even if they are the same entity. Director’s loans should neither be the first nor the last resort, but rather a judiciously considered financial tool.
If you have read this far and are wondering whether you are already in trouble? You may well be. No need to delay. Reach out to us & let us help out. No need to ignore that gut feeling of trouble today.
If you are about to face the tax hangman, me hearty?