There are risks in having an overdrawn shareholders account.
As mortgage brokers we see a lot of business financials from self-employed people and many of those have an overdrawn shareholders account. Some are quite substantial and the disturbing thing is that there is often little or no understanding of what this means.
Don’t bury your head in the sand on this … it is something that you need to be aware of now, before it becomes a serious issue.
A Debt To The Company
In simple terms an overdrawn shareholders account is a debt that the shareholder owes to the company.
Many small business owners don’t care too much as they treat any money within the company as their own money. There are risks with this attitude;
- A company is a separate legal entity
- As a company director you have certain financial responsibilities
We are advised that interest must be charged on overdrawn current accounts at FBT prescribed rates unless steps can be taken to minimise such a charge which is currently 6.22% so higher than most mortgage interest rates. It is therefore an expensive way to fund a debt and is often an unnecessary debt to have.
Company Shareholders Need To Understand This
Most small businesses that are operated through a company structure use a limited liability company which in most cases limits the liability and financial risk to the value of assets of the company. This means that should a company (business) fail then a liquidator will look to sell any company assets, collect any debts owed to the company and then use the money to satisfy any money owed by the company.
As mentioned, an overdrawn shareholders account is a loan from the company to the shareholder and this is why you will see the “shareholders account” showing as an asset in the company’s balance sheet.
In other words, if your company fails for whatever reason and a liquidator is appointed, then they will most certainly demand repayment of the overdrawn shareholders account.
If you are not in a position to repay that debt then they have every right to come after you for that money which can lead to a court judgement, personal bankruptcy and the sale of the family home to satisfy that debt.
Yes, it sounds EXTREME but it does happen!
Personally we have seen the results of this on a number of occasions and if a creditor is the IRD then they are more likely to chase any money owed from your overdrawn shareholders account.
How Has The Shareholders Account Ended Up Like This?
In simple terms most shareholders accounts end up overdrawn when the shareholders take higher drawings from the company than the company is able to fund from profits – effectively living beyond your means.
Often this happens when a shareholder has been used to living on a certain income and then business profits have dipped, and these situations often resolve themselves when the company recovers.
There are two occasions where shareholders and company directors should be particularly concerned;
- Where a business is not experiencing increasing profits and shareholders accounts are getting more into debt every year.
- Where a business is experiencing cashflow difficulties and/or is not able to pay creditors or the IRD on time.
These two situations generally point to a situation where the shareholders are drawing an income that is too high for the business to sustain and unless changes are made there is a high risk that the business will eventually be put into liquidation by the IRD, creditors or the company directors.
Often these situations come about as the shareholders are spending more than the company can afford to pay them, and as such cannot continue. The company accountant should raise this issue with you, but if they don’t or if you don’t understand this than you need to spend some time with your accountant or business consultant to ensure you do.
Clean Up Your Overdrawn Shareholders Account
If you own a small business and have not reviewed your shareholders account then it might be about time you did. In addition if you act as a trustee to any self-employed person that potentially has an overdrawn shareholders account then you need to ensure that it is being addressed, especially where income from the business is being used to pay a mortgage or loan secured against property owned by the trust.
It may be as simple as raising finance on the family home to repay the debt (shareholders account) to the company which is (1) a cheaper way to fund the debt, (2) injects capital back into the business which can be used to repay other more expensive debt and (3) eliminates the risk.
In some cases it may not be possible to immediately repay your shareholders account. If this is the case you need to understand why things have gotten into the position and implement a strategy to get the account paid off as quickly as possible.
In Summary
An overdrawn shareholders account is a debt owed by the shareholders to the company and the shareholders will be paying interest on that debt. Often these situations come about as the shareholders are spending more than the company can afford to pay them, and as such cannot continue.
It is important that an overdrawn shareholders account is addressed.
