Expect to receive a demand from a liquidator.
Using a corporate entity to trade a business enterprise gives several benefits. One benefit is minimising a director’s exposure to personal liability. However, at Worrells we frequently identify instances of directors becoming personally liable due to “Director Loan Accounts”. Such loan accounts are an asset that we as liquidators are required to recover from the directors. This in turn creates a mechanism in liquidation that effectively pierces the corporate veil.
Generally speaking from what we see at Worrells, at some stage the company was profitable and generating surplus cash flows at which time the directors are drawing a small wage or director’s fee. At this juncture, with tax minimisation in mind, the directors will draw further amounts from the company’s cash resources. The additional withdrawals will not appear as a wage or directors fee expense in the profit and loss, but as a company asset in the form of a Director Loan Account appearing on its balance sheet.
Frequently, Director Loan Accounts are undocumented and therefore can easily be called upon at any time. In a liquidation scenario, a liquidator will issue a demand that the funds, representing a debt due to the company, be repaid immediately. If payment is not forthcoming the liquidators can issue legal proceedings to recover the amounts as a debt due.
So how might directors of profitable companies draw on surplus funds and avoid being personally liable to repay a Director Loan Account demand from a liquidator?
One option is increasing the wage or directors fees being paid to the directors and have the company remit Pay as You Go Withholding to the Australian Taxation Office (ATO). Alternatively, if the directors are also shareholders (which is often the case) the company can declare a dividend. Depending on the company’s tax circumstances, shareholders might enjoy the benefit of a franked dividend where the tax credits paid by the company are also distributed to them.
Directors that are also shareholders should consider the implications of Division 7A of Part III of the Income Tax Assessment Act 1936 (Division 7A). Unless certain exclusions apply, amounts advanced by a company to a shareholder (or their associate) are treated as dividends under Division 7A, which is designed to prevent a tax free distribution of profits. So it is possible for the ATO to classify the Director Loan Account as a dividend, regardless of how it is recorded in a company’s financial statements.
It would be remiss to ignore the risks for directors owed amounts by the company. If the company goes into liquidation, the voidable transaction recovery provisions will be available to the liquidator. This means that if a director received payments prior to liquidation (either partially or in full), those payments can be at risk of being voided on the basis that they might represent preferential payments, uncommercial or unreasonable director related transactions.
If a liquidator identifies a Director Loan Account it is reasonable for the director to expect to receive a demand from the liquidator. However, a liquidator’s perspective is focused on the director’s capacity to repay the debt due, which nullifies the affect of using a company in the first place. With this in mind, directors should ensure that they seek appropriate advice prior to implementing a director loan account to be sure that they are aware of all of the implications.