As a director of a company, there are certain times when you may need to take out some money for certain short-term or one-off expenses, which is where a director loan comes in, becoming a very common and popular method of developers borrowing money rather than taking out a personal loan from the bank.
The actual way these loans work can be a little confusing however, so to make this much clearer and to help you decide whether it could be a good idea to take out a directors loan, we have compiled a full analysis of how these loans work, and when the best time to use them is.
How Does A Director’s Loan Work?
A director’s loan refers to money that you take from your company’s account that is not classed as dividends or as part of a salary.
It is therefore money that the director will borrow, usually for a short-term investment, that they will be expected to repay in due time.
The money you gain from the company as part of a director’s loan is also not money that you have previously paid or loaned into the company, but instead, money that is being taken directly from the company that will need to be paid back.
What Is A Director’s Loan Account?
A director’s loan account (DLA) is an account of the financial records between a director and their company that provides details on any owed money between the two.
While it will therefore record amounts that are due to the director from the company, it will also indicate any amounts from the director (debtor) to the company, making it useful for managing how much is still owed when taking out a director’s loan.
This does not only need to be money leant from the company to the director however, if the company is a close company, then any money that has been lent to a director’s family, business partners or friends is also recorded.
This is usually only applicable to close companies which are controlled by five or fewer participators, with a DLA being a useful way to keep track of how much needs to be repaid down the line.
A director also won’t be able to get out of a director’s loan if it is overdrawn by lending the money to someone close to them.
If they do, they will still incur a tax penalty of 32.5% of the loan amount.
Why Take Out A Director’s Loan?
Many directors will make the decision to take out a director’s loan if they need extra money for short-term investments, rather than taking out large sums for long-term projects as many people would do when taking out a loan from the bank.
This is because of the ease, flexibility and speed with which you can set up and receive the money from a director’s loan, and since there are no restrictions on what you can use a director’s loan on, this makes them very handy for solving smaller issues when you may be struggling financially in that moment but know you will be receiving money soon.
With that being said, since it is still taking money out of the company itself, a director loan should still be a last resort for short-term borrowing, otherwise you can end up building up the amount owed in the DLA, which can negatively affect both you and the company.
Therefore they are usually only taken out for urgent cash flow needs such as home repairs or children’s school fees, but the most important factor is that the director knows they will be able to pay this amount back in time.
How To Re-Pay A Director’s Loan
As a director, you do get a fair amount of control regarding how exactly you pay back the money you have borrowed, however there are 3 common methods people will follow when repaying. These 3 methods are:
- Pay Cash – Paying off the loan from your own personal account is the easiest and most genuine way to repay, and is the method a lot of people will use since it can be done instantly if you have the money ready.
- Using Dividends – As a director, you have the ability to issue dividends however frequently you would like, just as long as there is still sufficient profit within the company for you to do so. You can therefore draw out dividends and use this amount to pay off the loan, rather than the dividends going straight to your personal account.
- Salary – If you are unable to pay using dividends because the company’s profits are not strong enough, you are still able to use your salary, along with any dividends, to pay off the amount, which is still considered a legitimate method of repaying a director’s loan.
Taking Out One Directors Loan After Another
There have been cases in the past where directors will avoid paying back the amount to a company by paying the amount back in full, before then taking out another director’s loan straight after.
While you cannot take out multiple loans at once, this is a frowned upon method known as ‘bed and breakfasting’ that some directors have tried to utilise, however, it is very unethical and has been cracked down on by the HRMC who have issued new rules and sanctions to stop this from happening.
These new rules state that once a director’s loan of over £10,000 has been repaid, a new loan cannot be taken out within the next 30 days, and even then, the new loan will still attract tax.
This has been implemented to ensure directors are not using their company’s money unfairly since a director’s loan should always only be an unavoidable last resort.
Summary
While there have been cases of them being used unethically in the past, directors’ loans should only be used when a director needs an urgent cash flow for a short-term issue that they know they will be able to pay back.
They are therefore much quicker to implement than other types of loans and usually allow you to borrow much less money.