A director’s loan is a financing option, but many business owners aren’t aware of the details. Make sure you understand when and how to execute it correctly.
Introduction: What Is a Director’s Loan?
A director’s loan is a way for a director of a private company to borrow money directly from the business for personal use. Often referred to as a shareholder loan, this arrangement is strictly regulated under the Income Tax Assessment Act 1936, particularly Division 7A. If you’re considering borrowing money from your company, it’s crucial to understand the tax implications and legal requirements involved. Director’s loans are not the same as taking a salary or dividend—they are a separate transaction that must be properly documented and repaid. Failing to comply with the rules can lead to significant tax consequences for both the company and the director. Before you borrow money from your business, make sure you’re familiar with the relevant laws, including how the loan, interest, and repayments should be handled to stay compliant.
A directors loan is a financing option, but many business owners aren’t aware of the details. Make sure you understand when and how to execute it correctly.
As a director or owner, you’re entitled to take loans from your company.
A company is a separate legal entity, which means director’s loans are treated differently from personal loans because the company’s finances are distinct from your own.
The specifics of this type of loan are very different from normal personal loans. The restrictions and tax implications contrast sharply in some cases.
Provided you know all the details and you’re on solid financial ground, it may be a good financing option. Otherwise, it could be more trouble than it’s worth. A director’s loan isn’t a good way to get an interest-free loan, and you shouldn’t see it as such.
You can learn about the specifics in this post. Make sure you pay special attention to the tax implications. It’s a special financing case and it could easily be a mistake if all the finer points aren’t observed.
How Do Director’s Loans Work?
A director’s loan, in short, is borrowing money from the company by the director. Directors loans are a common way for directors or shareholders to access company funds, but they must be properly managed and reported.
There are many limits to the loan, though. Also called a shareholder loan, this encompasses any money taken out that isn’t wages or dividends. Director’s loans are not considered a business expense and cannot be deducted as such.
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, which sets out the tax rules and required minimum yearly repayment obligations for directors loans. That means that the borrower likely doesn’t have to pay tax on the loan amount, provided the required minimum yearly repayment is made.
That’s true in so far as the loan is not a payment. If the cash is a payment for Division 7A purposes, fringe benefits tax will apply. This is also called a benefit in kind. In this case, Division 7A does not apply to the loan amount. For instance:
As a director and sole shareholder of his company, James decided to use the company car. The provision of the asset to an employee is a payment in terms of Division 7A.
As an employee, James also received a loan from his company interest-free. The loan is recognized as such under 7A as well.
The use of the car is a fringe benefit, rather than a dividend. Therefore, it is subject to an FBT tax charge.
The loan, however, is not a fringe benefit under Division 7A.
You, the director or shareholder, need to track the money in a director’s loan account, which is a record-keeping tool used to monitor all amounts borrowed from or lent to the company by the director. The director’s loan account must be reported on the company’s balance sheet as either an asset (if the director owes the company) or a liability (if the company owes the director), depending on its status. The loan value is also recorded in your personal assessment tax return.
Basically, when a director or shareholder takes out more money than gets put into the company, it’s a director’s loan. A company can lend money to a director, but must do so on commercial terms, and the company pays or has paid out funds to the director. If a new loan is made shortly after repaying an original loan, anti-avoidance rules may apply, and the original loan may still be subject to tax. If the director fails to repay the loan, or if the debt is forgiven, there may be tax consequences, such as the loan being treated as a dividend. Directors loans must be repaid according to the required minimum yearly repayment to avoid being taxed as dividends. Loans secured against real property may have different terms, such as longer repayment periods, sometimes up to 25 years.
Taking Out a Director’s Loan
Borrowing money from a limited company is simple, but it needs approval from shareholders.
If it’s a sole proprietorship, that approval is not implied. You must keep a written record of your own approval on file.
The loan agreement must be in force before the lodgement day for the company year income. Otherwise, the loan does not comply under Division 7A.
The agreement doesn’t need to follow any specific format. However, the agreements must include:
- Identity of the lender and the borrower
- The conditions of the loan (amount drawing date, rate of interest, and terms of the loan)
- Signature of the lender and date
Note that any withdrawal of company funds that aren’t wages or salary dividends fall under a director’s loan. This means that you could accidentally take a director’s loan under some circumstances. For instance, if dividend distribution happens without the profits to back it.
Loan Agreement and Interest Rate
Whenever a director’s loan is made, a written loan agreement is essential. This agreement should clearly outline the loan amount, the interest rate payable, the repayment schedule, and the date the loan is taken out. The interest rate must meet or exceed the minimum rate set by the Australian Taxation Office (ATO); otherwise, the loan could be treated as a dividend for tax purposes, leading to unwanted tax consequences. The agreement should also specify the minimum yearly repayments required to keep the loan compliant with Division 7A. Having a written loan agreement in place protects both the company and the director, ensuring there’s no confusion about the terms and helping to avoid disputes or issues with the ATO down the track. Always make sure your loan agreement covers all essential terms and is signed by both parties before any money changes hands.
Repayment and Taxation
Minimum yearly repayments on director’s loans fall under Division 7A. If the minimum payment is not made, the deficit amount becomes a dividend in that financial year under Division 7A.
You must make the minimum repayment amount by June 30th of the year they are due.
Minimum loan repayment amount calculates on the basis of the total loans made to a shareholder or director.
In a way, director’s loans are a type of interest free loan, because you pay the interest to the company. However, the loan should have an interest rate based on the loan amount. The interest figures into the lender’s (company’s) assessable income.
Limited Company Considerations
Director’s loans are only available to directors who are also shareholders in a private company—public companies and sole traders cannot use this option. Before proceeding, it’s important to assess the company’s financial health to ensure that lending money to a director won’t jeopardize the business. All director’s loans must be accurately recorded in the company’s tax return, and the director’s loan account should be kept up to date with every transaction, including repayments and interest payments. This helps maintain transparency and ensures compliance with tax laws. Proper record-keeping is not just good practice—it’s a requirement for limited companies, and it will make preparing your company tax return much easier at the end of the financial year.
When to Take Out a Director’s Loan, and When Not To
As a director of a limited company, you’re not liable for paying any of the company’s debts. However, that doesn’t mean you should see a director’s loan as an easy source of capital.
While a director’s loan is a potential source of quick capital, it’s not always advisable.
Lifestyle and personal expenses aren’t a good reason to take a director’s loan. Nor are any expenses, realistically, if those mean that your ability to run the business successfully will suffer.
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.
Also, a director’s loan is not about lending money to yourself to pay personal bills or personal tax liabilities. It’s meant to be a short term loan to cover expenses related to running the business.
Only take out director’s loans when and if you will make sure the loan is repaid. You can find more information about loans by private companies on the ATO website.
Interest-Free Loan or Potential Hazard?
It’s a common misconception that a director’s loan is an interest-free way to access company funds. In reality, interest must be charged on the loan amount, and minimum yearly repayments are required. If you fail to charge the correct interest or don’t make the required repayments, the ATO may treat the unpaid amount as an unfranked dividend, which can have serious tax implications. Director’s loans should never be used to pay personal bills, cover personal tax liabilities, or supplement wages. Using company money for personal expenses can lead to compliance issues and unexpected tax bills. Always consider the tax consequences before taking out a director’s loan, and make sure the loan is structured properly to avoid turning a short-term solution into a long-term problem.
Alternatives to Borrowing from Your Business
Before you decide to borrow money from your business, it’s wise to explore other financing options. An unsecured loan from a third-party lender may be a better fit, especially if you’re a sole shareholder or sole trader. A reasonable person would weigh the pros and cons of each option, considering both the business and personal financial impact. Director’s loans should not be your last resort, but they also shouldn’t be your first choice for funding personal needs. Always review the loan agreement carefully to ensure it includes all essential terms and meets legal requirements. If you’re unsure, seek professional advice to make sure you’re making the best decision for your business and your personal finances. Remember, borrowing from your company is a significant step—make sure it’s the right one for you.
Interest-Free Loan of Potential Hazard?
Many business owners will think of a director’s loan as an easy route to quick capital. But this is hardly a good use of this benefit. The point of the director’s loans is to have fast access to company funds when opportunities or crises appear.
When taking out a director’s loan, keep good 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. If you need financing in a pinch, that’s what we do best. Contact us today to find out if you qualify for an unsecured loan. You should also be aware of the factors to consider before applying for a small business loan.
