As the director of a company, you might consider a director’s loan (also called a shareholder loan) when you need money urgently but are unable to get a loan from the bank. You may consider taking a dividend from your company but this may not be possible if your company is not profitable. You might then consider a director’s loan which is money taken out from your company’s accounts that are not used for salary, dividends, or expenses. With this comes risks and legal issues which you need to be aware of.
What is a Director’s Loan?
There are two types of director’s loans.
- When the director borrows money from the company which will inevitably need to be paid back; OR
- When the director loans money to the company which the company will be liable for. This usually occurs when extra funds are needed with the start-up of the business or to keep things running during times of low cashflow. The company then becomes the debtor and is seen as a separate legal entity owing money to the director, who is now a creditor.
Why Would You Need a Director’s Loan?
Directors’ loans are not something you would take on a regular basis and should only be used in emergencies where personal funds are insufficient.
When a loan is made by the company to a director, it is usually for large but short-term expenses related to running the business and not to pay personal bills or personal tax liabilities. They tend to be unexpected and consist of one-off expenses. An example of this is where there a sudden need by a director to pay for water restoration services.
Where the company is the lender, this gives the director access to more money than otherwise obtainable via salary or dividends.
Never use a director’s loan to supplement wages. If you can’t afford the withholding or income tax on wages, a director’s loan is not the solution.
How Does a Director’s Loan Work?
Firstly, the director’s loan will need to be approved by shareholders. An exception is if your business is structured as a sole trader. If so, you will only need to keep a written approval on the record.
You will also need to ensure that the loan is set up properly. Specifically, there must be a loan agreement active before the company’s yearly income is lodged. The loan agreement will need to include:
- The identity of the parties (the company and the director)
- Any essential terms and conditions of the loan (including the amount, repayment details and interest rate payable – which come into the company’s assessable income)
- The signature of the parties (the company and the director)
- The date
Director’s Loan Repayment and Taxation
Whether you take the loan out in one lump sum or over several instances doesn’t change its nature. As a loan, it falls under Division 7A of the Income Tax Assessment Act 1936. That means that the borrower likely doesn’t have to pay tax on the loan amount.
Minimum yearly repayments on director’s loans fall under Division 7A. If the loan is not set up properly (for example, there is no loan agreement) or you do not make the required minimum yearly repayment on the loan by 30 June, the deficit amount becomes a dividend in that financial year under Division 7A. This means that you can be taxed on the entire amount.
What are the Dos and Don’ts of a Director’s Loan?
Unfortunately, most loans of this sort aren’t the result of careful planning, but of shareholders or directors looking to solve a short-term cash flow problem. Here are a few red flags that indicate you probably shouldn’t be borrowing from your company:
- Your company has cash which is surplus to normal operational requirements (i.e. you won’t need it back in a hurry).
- The loan will only represent a small percentage of your overall company assets (e.g. <10%).
- You’ve got a compliant loan agreement in place provided by your tax accountant.
- You have a plan for repaying the funds, along with the associated interest charges, within the time frame specified in the loan agreement, without resorting to borrowing more company money.
- You’re using the cash to fund lifestyle expenses.
- You’re limiting the amount of cash needed to operate the business comfortably.
- You’re borrowing cash because your wage is insufficient (often because the company cannot afford the withholding tax and superannuation on a wage increase).
- You’re borrowing cash to pay personal tax bills.
- You’re not able to repay or you have no plans to repay.
When taking out a director’s loan, it’s important to keep records of all the amounts and dates. It’s also important to have written confirmation of approval. Both the lender and the borrower need to appear on the written record, even if they’re the same person or entity. Director’s loans shouldn’t be your last resort, but they shouldn’t be the first either.