National insolvency and business recovery firm Jirsch Sutherland has warned company owners and directors to understand the risk of using debit loan accounts, after noticing an increase in bankruptcies as a direct result of director loans. And accountants can help prevent their clients getting into difficulty.
“Used wisely, director loans can be useful. However, there are some circumstances where they present a major risk. One particular circumstance is during a liquidation,” says Jirsch Sutherland Partner Stewart Free, a bankruptcy specialist. “Many business owners use debit loan accounts to mitigate tax or improve cash flow during tough times but the issue is that if the company gets into strife, the owner can get caught out because they are responsible for the debt. I’m seeing a lot more people become bankrupt as a result of this.”
Channelling transactions via a loan account rather than allocating them to wages or fees avoids PAYG withholding tax and other employee entitlements such as workers’ compensation. On the company’s balance sheet, the amount borrowed is recorded as a “Director Loan Account”. But this also means it can be recoverable as a debt due to the company.
If conditions are met, such as the company being solvent, then a director’s loan falls under the Division 7A provisions of the Income Tax Assessment Act. This requires a loan agreement to be put into place and the loan plus interest to be repaid over seven years. These requirements prevent the Australian Tax Office from taxing the loan as a deemed and unfranked dividend.
However, Division 7A (Div 7A) prohibits tax-free distributions of profit to shareholders and their associates and problems arise when a company becomes insolvent and enters liquidation because the liquidator can then demand the director repay the loan to the company. The director may also find themselves facing bankruptcy.
“Be aware that any transactions occurring in the director’s loan account will be scrutinised by a liquidator to determine if there are any that are unreasonable pursuant to s588FD of the Corporations Act 2001,” explains Free. “Accountants who are concerned their clients may be at risk from their loan strategy may want to advise them to take stock of their situation and evaluate the level of liability they are building up.”
Need for careful monitoring
Jirsch Sutherland Partner Chris Baskerville says Div 7A loan accounts should be monitored carefully.
“Because the loan is an asset that is due to the company, a liquidator is entitled to demand the loan monies back,” he says. “And once the loan no longer complies with Division 7A, it can be deemed by the Commissioner of Taxation to be an ‘unfranked dividend’ for the whole amount, and subsequently included in the borrower’s income tax.”
Baskerville says unless you pay a Div 7A loan back in the given tax year, the amount may be deemed as an unfranked assessable dividend that ends up being taxed in that director’s hands, at their marginal tax rate.
“Interestingly, the loan amount must be ‘deemed’ by the Commissioner of Taxation, as opposed to individuals who can ‘self-declare’ their taxable income,” he says. “The situation can bring about a ‘double-whammy’ in that the director may find they need to repay the loan back to the company in full while the ATO adds the loan amount to the director’s total income – meaning the director ends up paying a lot more tax.”
Directors with a loan account whose company is facing liquidation can either repay or offer to repay the loan amount, or any liabilities that the company has to the director can be offset against the outstanding loan amount. While unlikely to be an option if a company is in poor financial health, if a company has franking credits, it could declare a dividend and credit the dividend to the loan account. The franking credit can then help with any tax payable.
About Jirsch Sutherland
Established in 1984, Jirsch Sutherland is one of Australia’s leading national independent insolvency specialists. The Jirsch Sutherland team works closely with small and mid-size accounting, finance and legal firms – and their clients – to provide a wide range of expert corporate and personal insolvency services including liquidations, voluntary administrations, receiverships and bankruptcy.
With head offices in Sydney, Melbourne, Brisbane, Newcastle and Perth, supported by a network of regional offices, Jirsch Sutherland’s national reach combined with a local presence underpins the company’s ongoing.
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