A director’s loan is a unique financing option — but many business owners aren’t aware of the potential risks and obligations associated with them. Here’s what you need to know about director’s loans.
If you are a director or owner of a company, you’re entitled to take loans from the company you own. A director’s loan, or a shareholders loan, is a financing option that is often taken advantage of by business owners. It’s important, however, to ensure that you are aware of how and when to execute a director’s loan.
Director’s loans are very different from personal loans, with many specific tax implications and restrictions that must be understood. If you’re aware of the complex details regarding director’s loans and your business is operating with a well-organized accounting strategy, director’s loans can be a good financing option.
Diving head first into director’s loans without fully understanding all the details, however, can generate significant problems for your business. A director’s loan isn’t simply an interest-free loan, although many business owners make the mistake of viewing it as such.
It’s important to understand the tax implications and other specifics of director’s loans. As a specialized financing case, director’s loans present ample opportunities to make mistakes — here’s what you need to know.
What is a Director’s Loan?
Put simply, a director’s loan is money borrowed from a company by the company director. If you, as a company director, a shareholder, or someone affiliated with a shareholder, take money out of your company that isn’t a dividend or wages, then it’s likely that you’re borrowing company money.
The nature of a director’s loan or shareholder’s loan doesn’t change whether you take the money out of the company in a single lump sum, or over several instances. In either case, taking money out of a company in this manner is a loan and likely falls under Division 7A of the Income Tax Assessment Act 1936, which means — in most cases — that the loan could be subject to tax.
A borrower taking money from a company in this manner is not likely taxed on the capital removed if the loan is not a payment. If the money taken from the company is defined as a payment under Division 7A purposes, it’s likely that the fringe benefits tax will be applied, which is also referred to as a benefit in kind. In this specific case, Division 7A doesn’t apply to the loan amount.
For example, a director and sole shareholder of a company may decide to use a company car. The provision of an asset to an employee, under the terms of Division 7A, is a payment. As an employee of the company, the director also received a loan on an interest-free basis from the company, This loan is also recognized under Division 7A.
The use of the company car in this example is a fringe benefit, rather than a dividend. The car is therefore subject to fringe benefits tax. The loan, however, is not a fringe benefit under Division 7A.
The director or shareholder of a company must track the money in a director’s loan account. The amount of the loan should also be recorded in the personal assessment tax return of the director or shareholder.
What are the Potential Risks of a Shareholder or
Director’s loans can cause difficult problems in a business when they are taken for reasons unrelated to the company itself, such as increasing the salary of a director.
Director’s loans often start small, but rapidly increase in size, because they are fed by shareholders or directors drawing capital from a business. In many cases, there is little to no oversight over these transactions other than by the person borrowing the capital.
Under Division 7A, any shareholder or director’s loans should be established through a formal loan agreement that details repayment terms and interest charges. Not following this procedure can cause significant problems.
Director’s loans can also raise red flags with the ATO when disclosed in company tax returns — if a director’s loan is not administered through a proper loan agreement with relevant documentation, you may be taxed on the entire loan amount.
Lastly, director’s loans may reflect poorly on the overall financial health of a business if not administered and managed correctly, creating obstacles when a business owner chooses to sell their business or bring in employee shareholders.
When Should a Director’s or Shareholder’s Loan Be
Borrowing company capital can be a strategic move in specific, limited circumstances — especially in restrictive lending markets. There are a number of other scenarios in which a director’s or shareholder’s loan can be the right choice.
A company may have surplus cash which is not immediately required for normal operational requirements. In this case, a loan that represents only a small percentage of overall company assets, such as less than 10 percent, may be an effective finance option.
When administering a Director’s loan, it’s important to ensure that you’ve drawn up a compliant loan agreement with your tax accountant, and have a clearly defined plan for repaying the loan — along with interest charges — within a specific time frame specified within the loan agreement.
Director’s or shareholder’s loans should not be used in order to solve short term cash flow problems. Borrowing company funds to fund lifestyle expenses, for personal cash or bills, or because your wage as a director is insufficient, is likely to disrupt the financial health of your business.
What to Know Before Taking Out a Director’s Loan
Borrowing money from your company through a director’s or shareholder’s loan is relatively straightforward, but requires approval from shareholders. If your business is a sole proprietorship, this approval is not implied — you’ll need to keep a copy of your own written approval on file.
The loan agreement you use to administer the loan must be in force before the lodgement date of the company year income in order to be compliant with Division 7A. The agreement doesn’t need to follow any format in particular, but must detail:
- The identity of the borrower and the lender
- The conditions of the loan, such as the rate of interest, amount, drawing date, and terms of the loan.
- The signature of the lender, and date
Repayment of Directors Loans
The minimum yearly repayments on director’s and shareholder’s loans fall under Division 7A. If the minimum repayment on a director’s loan is not made, the deficient amount biomes a dividend in that financial year under Division 7A rules.
Borrowers must make the minimum repayment amount before June 30 of the year in which they are due. The calculation of the minimum repayment amount is performed on the basis of the total loans made to a shareholder or director.
A director’s loan is a potential source of quick capital, but it’s important to ensure you’re using director’s loans for the right reason. Lifestyle or personal expenses aren’t good reasons to take a director’s loan, nor is a director’s loan to be used to supplement wages.
Overall, a director’s loan is intended to function as a short term loan to cover expenses related to the operational costs of a business and should be treated accordingly.