Director loans (debit or credit) are not a new topic in the SME space. But when a company enters into insolvency, whether via liquidation or Small Business Restructure (SBR), these loan accounts can quickly become a focal point for liquidators and the ATO.
Liquidation
In a liquidation:
The treatment of a credit loan depends on whether it is secured or unsecured.
A debit loan is considered an asset of the company, and the liquidator is duty-bound to seek its recovery.
Credit Loans
In liquidations we manage, debit loans are commonly undocumented and rarely secured. Directors therefore rank as ordinary unsecured creditors and fall to the back of the priority line when it comes to distribution from the liquidation.
Alternatively, if the same loan was properly documented and registered on the Personal Property Securities Register (PPSR), a director may push their way to the front of the pack to claim priority over certain asset recoveries. Suddenly, a loss turns into partial (or potentially full) recovery. PPSR requirements are complex, and we always recommend a director seek independent legal advice prior to implementing a debit loan account to ensure proper registration occurs.
Debit Loans
On the other side of the ledger, debit loans also face scrutiny in a liquidation scenario. On face value, a debit loan on the balance sheet is considered to be an asset of the company, and the liquidator will, where appropriate, pursue recovery for the benefit of creditors.
A common pitfall we see is that directors regularly take undocumented drawings in lieu of PAYG wages, which get allocated to a debit loan account. While this account may usually be cleared out at year end (via distribution of profits), insolvency may intervene, and liquidation may occur while the loan account is at large. If the account is undocumented, and drawings are not appropriately backed up by documentation or resolution, the account will be called upon by the liquidator.
Further, even if drawings were documented, a liquidator will need to give consideration to the appropriateness of drawings where the company may have been ostensibly insolvent. This may enliven voidable transactions or other claims that may be pursued by the liquidator.
While it goes without saying, directors who are shareholders will also have to be conscious of Division 7A implications associated with any loan account.
Small Business Restructure
The topic of ever-growing popularity in the insolvency industry presents a different set of challenges to debit and credit director loans.
Debit Loans
Debit loans face a significant degree of scrutiny, particularly by the ATO (often the largest and/or only creditor), in SBRs. The ATO will request to see the underlying ledger of any director loan account and compare the transactions against the ATO debt.
Where the balance of the loan account was increasing while the tax debt remained unpaid, this can significantly affect the ATO’s view on accepting a proposal.
In addition, a Restructuring Practitioner will also give regard to any debit director loan account when comparing the outcome of the SBR against a hypothetical liquidation. If the director loan account is substantial and appears recoverable, this may encourage creditors to vote against an SBR proposal.
Credit Loans
What we often see in practice is that credit loan accounts with the director (or other related parties) are forgiven contingent upon the proposal being accepted by creditors. The main benefits of this to the SBR are twofold:
It demonstrates good faith and support for the business’s survival by the director, which can be looked upon favourably by creditors.
It reduces the overall claims pool and therefore improves the return to unrelated creditors.
Notwithstanding the above, the forgiveness carries significant risks:
The accumulated debt owing to the director under the loan account can often be substantial, and the forgiveness can represent a significant financial hit to the director.
Forgiveness can trigger unfavourable tax consequences, and directors are encouraged to seek independent advice and guidance to ensure this is adequately considered.
Conclusion – a once inconspicuous loan account hiding in the balance sheet can have significant ramifications on your client if the company requires insolvency assistance.
At Worrells, director loans are one of the first areas we look at when appointed. How they’re structured and documented can make a real difference to their treatment and the ultimate outcome for your client.
