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.
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.
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.
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.
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. 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.
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.
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.
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 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.