Loans to Directors are common but if not carefully managed...HMRC will tax them
What is a Directors Loan?
A Directors Loan is when you (or close family members) take money from your limited company that is not:
- Salary, Dividend or expense repayment, or
- Money you’ve previously paid into or loaned to the company, i.e. when starting up
You are required to keep a record of any money you take from or pay into the company. This is reported in the company accounts as a “Directors Loan account”.
Do I pay tax on my Directors Loan account?
This will depend on whether your Directors Loan account is overdrawn, i.e. you owe the company money. If you owe your company money, you or your company may have to pay tax on the director’s loan. Your personal and company tax liabilities will depend on how and when the directors loan account is repaid. There are 3 tax traps you need to be aware of that we will consider below:
1. Benefit in Kind may be payable by the director via your self-assessment tax return
2. Additional corporation tax may be payable by your limited company
3. Bed and Breakfasting rules
TAX CHARGE [1] Interest Free Beneficial Loans to Directors
Edward uses company funds to pay for personal purchases, he often owes the company money before a dividend or a bonus is voted to offset this.
Why does this matter?
Where the directors loan account is overdrawn and does not exceed £10,000 at any point in the tax year (not the company’s’ accounting year), then no tax will be charged and HMRC accept that this level of borrowing by directors can be a fact of life. However, where the directors loan account is overdrawn in excess of £10,000 and is provided either interest free or at a low rate of interest, then a taxable benefit in kind will be charged as a rule.
Note: HMRC publish what they consider to be a commercial rate.
How is the benefit in kind calculated?
[Opening Balance/Closing Balance] x Number of months in the year where the account is overdrawn
The tax charge will be as follows, let us consider Edward’s position:
He was overdrawn by £2k at the beginning of May 2020 and as at 05.04.2021 was overdrawn by £20k.
Edward’s Basic calculation:
Average loan account balance £2k+£20k =£22k/2 = £11k overdrawn for 11 months.
£11k x (11/12m) x 2.25% p.a. =£226 (this is the beneficial value of the nil interest director loan to Edward). Edward is a 40% taxpayer; therefore, he will pay income tax on the beneficial loan of £90.
As you can see, Edward was able to borrow £20,000 over 11 months at an income tax charge of £90. Therefore, it is a relatively cheap way to obtain a loan, the problems come when the loans remain outstanding over the longer term.
TAX CHARGE [2] Additional corporation tax (known as section.455 tax)
The main reason why Directors Loan accounts are a problem is because in the long term they can lead to this second more substantial tax charge on the company.
S.455 Tax only applies to Closed Companies, that is companies where up to 5 shareholders control the company or any number of directors and shareholders combined control the company. This is often the case in owner managed businesses. S.455 Tax is the main reason why shareholders do not take never ending loans from their company.
Note: even if you arrange for your parent or child take the loan, they will still be taxable on you.
S.455 tax applies as follows:
- It is a tax charge on the company, not the individual (but for owner managed businesses this can hurt your pocket in the same way).
- It is temporary, and you can get your money back as and when the loan is repaid.
- It is only charged on loans that last for more than 9 months after the end of the accounting period (the company’s year-end).
- If you do not repay some or all of the loan within 9 months of the end of the accounting period, s.455 tax being 32.5% of the outstanding loan balance will be payable to HMRC. HMRC will hold on to the S.455 tax paid for at least 12 months.
- You must reclaim the s.455 tax paid from HMRC who are very poor at paying this back automatically. Even when you submit your next corporation tax return to advise that a repayment of S.455 tax is due back to you, HMRC will ignore this and demand that a separate form L2P is completed to request the repayment.
Let us consider some examples…
[1] Tim is a director and 50% shareholder of a marketing company.
He owes the company £40,000 as at the company year-end 31st March 2021. He has until 1st January 2022 to repay the £40,000 in full otherwise s.455 tax at 32.5% of the balance will become immediately payable £13,000.
If Tim had repaid £20,000 of the £40,000 loan by 1st January 2022, a s.455 tax charge at 32.5% of the £20,000 balance will become immediately payable £6,500.
If Tim repays the loan in full or in part even just a few days late, HMRC will keep hold of the s.455 tax until at least 1st January 2023.
[2] Tim could have borrowed £40,000 on 1st April 2020
But, so long as he repays it by 31st December 2021 (21 months later) the company has no s.455 tax to pay.
He owes £40,000 @2.25% interest and is a higher rate taxpayer [40%]. He will pay tax as follows:
2020/21 = £40,000 @2.25% interest x 40% = £360 income tax on the loan
2021/22 = £40,000 @2.25% interest x (8/12m) x 40% = £240 income tax on the loan
Therefore paying £600 to borrow £40,000 for 36m. That is a very low-cost way to access £40,000 over that period of time.
TAX CHARGE [3] Caution: Bed and Breakfasting Rules – do not pay off and quickly redraw the loan
The B&B rules apply where a director’s loan exceeds £5,000 and there is an arrangement in place with a 3rd party to circumvent the s.455 loan repayment, i.e. a temporary overdraft is arranged to clear the directors loan before the S.455 tax is due and the loan is subsequently withdrawn again to repay the temporary overdraft within 30 days.
If the loan is repaid by processing a salary or dividend that has been subject to income tax, the Bed and Breakfasting rules do not apply.
Paying Off your Directors Loan
There are various ways to do this, the most common are listed below:
- Payment of Salary or a Bonus
- Dividend
- Forgiven – loans can in some cases be “forgiven” or “written off”.
- Loan (funds deposited back into the company)
What is the most cost-effective way of repaying a director’s loan?
Presently it is more cost effective to repay your directors loan account via dividend (where post tax profits are available to draw dividends). This is because no National Insurance contributions are payable on dividends.
Bear in mind the following…
[1] Higher corporation tax rates are coming as announced in the March 2021 budget, so it is advisable to get your directors loan account position in order, ahead of the increase in these rates.
[2] If the higher corporation tax rates will apply to your business in future, it may become the case that it is more cost effective to repay your directors loan account via a salary payment as the rate at which your salary will be tax deductible for the company could make the overall saving greater via the salary route.
Impact of the pandemic
- Company cashflow may have struggled
- Personal cashflow reduction may have put more strain on company funds
- Trading profits may have fallen, profit reserves may have significantly reduced, the company may be unable or limited in its ability to declare a dividend
- May be difficult cashflow wise to pay a salary or bonus if dividends are not an option, as PAYE may be payable.
Pandemic Problem: Illegal dividends
It is inevitable that many company Balance Sheets will have been eroded due to the pandemic. Let us consider some examples…
Edward draws out as dividends every year all post tax profits from the company. Therefore, the profit reserve is reduced to nil each year. He will not have any company reserves to draw as dividends to repay his overdrawn directors’ loan account.
If Edward were to declare a dividend when there was insufficient profit reserve, these would be considered illegal/ultra vires. Illegal does not mean criminal in this instance, but instead it means the dividends are repayable and would be taxed as “repayable loans”.
Tim on the other hand, has not drawn all available profits as dividends every year, and instead has built up a steady reserve of post-tax profits. Even though his company has generated a loss during the pandemic, the fact that a steady profit reserve has been built up over time, means he can still draw a dividend to repay his overdrawn directors loan account and avoid paying s.455 tax.
Best practice to ensure you avoid this position.
- Keep ypur financials up-to-date in XERO, so you can manage the £10,000 overdrawn threshold.
- Prepare interim management accounts to monitor the development of your profits, losses, and directors loan account, so you can be prepared ahead of your year end and determine the most suitable tax avoidance action. Imagine you left preparation of your accounts until the last minute, and you were subject to a s.455 tax charge. Not only would it come as an unpleasant surprise, but you would also then have the stress of the s.455 tax charge being immediately payable.
- By preparing interim management accounts, you could declare a dividend at various points in the year when profit reserves were available. You would then have interim management accounts to prove that the profit reserve was available at that point in time. If you had made a significant loss across the year and didn’t consider your directors loan position until 12 months later, you would not be able to draw an interim dividend.
NB. HMRC will be aware when company accounts are filed at Companies House if your Balance Sheet shows negative reserves, leading them to question the legality of any dividends drawn.
To summarise…
- Loans to directors have a low annual tax cost (where loans exceed £10,000 in a tax year), but the tax charge is annual and recurring.
- Biggest issue is s.455 tax affecting shareholders and their relatives.
- Managed well, loans can be drawn from the company for between 1-2 years without paying s.455 tax, so it can be a cheap way to access short term borrowing.
- Once s.455 tax is payable, HMRC will hold on to this money for at least 12 months.
- You have 4 years to repay the loan and reclaim your s.455 tax paid, otherwise HMRC will keep it.
Top Tips for managing your Directors Loan account
1. Know your Numbers – keep your financials up-to-date and monitor your profit reserves
2. Keep an eye on the time – make sure you pay off the right loans in the right order
3. Keep on top of any s.455 tax paid to HMRC; they will not prompt you to reclaim it
4. Be aware of long periods of account – the deadline may have passed without you realising
5. HMRC will issue penalties for incorrect returns that do not disclose s tax is payable
If you’d like to have a chat with us about our tax services and find more about what options you have to save tax, book a call to get started.