Shareholders and directors need to familiarise themselves with the implications of having a director’s loan account in their companies.
Especially – when the balance sits on the wrong side of the trial balance.
The colourful SME landscape in South Africa is characterised by many thriving entrepreneurial enterprises. Astoundingly, these successful initiatives are often driven by a one-man band. In these businesses, the shareholder/s of the company is generally also the director/s of the company. The start-up of the company is usually funded by these individuals who pour in capital in exchange for shares in the company.
THE DAWN OF THE DIRECTOR’S LOAN ACCOUNT
A portion of the funding by directors may however be recorded as a loan from the shareholder/director to the company. Hence, the director’s loan account. From the company’s perspective, there is now a huge fat credit balance owing to the shareholder/director on the balance sheet.
Often, directors may wish to pay personal expenses from the business bank account. This is not a problem – as these payments are recorded against the director’s loan account. In effect, the huge fat credit balance in the company’s records is decreasing: The company is ‘repaying’ the director.
From a technical point of view – any loan transaction between the company and its shareholders/directors should be regulated and subject to certain terms and agreements in line with the Companies Act. However, where the shareholder of the company is also the director – there is no quorum among directors to consider. There is also less risk of reckless management by the director as their own stakes are on the line.
PROBLEMS WHEN A DEBIT TURNS INTO CREDIT
If a director does not carefully keep track of what’s recorded against their loan account – it may go into a debit. This means that the director will now owe the company money. It has massive implications from a tax point of few: The Income Tax Act stipulates that a debit loan will be treated as a deemed dividend paid to the director on the last day of the tax year. The company will be liable to pay tax at a flat rate of 20%.
Director Z is a shareholder/director in Company ABC and his loan account has a debit balance of R23 500. Director Z has the following options:
#OPTION 1: DECLARE THE DIVIDEND
Close to year-end, Director Z can declare a dividend equal to the amount in debit and the company will pay over the divided tax to SARS. The loan account of Director Z will be zero at year-end. For example:
- Net dividend paid to director: R23 500
- Gross dividend declared to SARS: R29 375 (R23 500 x 100/80)
- Dividend tax be paid to SARS: R5 875 (29 375 x 20/100)
#OPTION 2: DECLARING SALARIES
Director Z may wish to declare the amount as an additional net salary paid out to him. This option should ideally be exercised before year-end e.g. in February. Should the additional salaries be declared after year-end during the EMP501 reconciliation to SARS – this may attract interest and penalties. This option will also clear the director’s loan account at year-end
The director’s tax bracket should be considered when deciding which option will have the most favourable tax rate.
#OPTION 3: RECORD INTEREST
A company’s financial statements should be prepared within 6 months after year-end. By this time however, no dividend can be declared for the closed financial year and the EMP501 has already been submitted. The company should then record interest at rate linked to the official interest rate (prime). Any difference between a lower interest rate and the official interest rate will be treated as a deemed dividend. For example:
- Prime rate at year-end: 25%
- Interest calculated: R2 409 (R23 500 x 10.25%)
- Total balance of loan account: R25 909 (R23 500 + R2 409)
This option should be considered as the last resort: When a director’s loan account keeps growing each year – odds are that the director won’t be able to repay the full amount. When the loan is eventually become irrecoverable and written off – this obviously has an enormous once-off tax effect.
KEEP TRACK AND ENJOY THE BENEFIT WITHOUT ANY HASSLES
Being proactive is the key to avoid any nasty surprises. It’s advisable that directors review an updated schedule of their loan accounts on a monthly basis.
Alternatively, directors may consider the following if they have solid cash flow position: Draw a lump sum from the company at the beginning of the year and transfer this money to your personal account. Make personal payments from this account and earn interest in your personal capacity. This interest will be tax free (natural person exemption) – as oppose to the company paying tax. At the end of the year, the loan can be repaid to clear the initial loan amount at the beginning of the year.
As a director and shareholder, the convenience of having a loan account in your company should never become a headache – it’s a privilege. It should serve as a reward for having the guts and taking the gigantic leap of starting your own successful business.