If you’re a company owner-manager, do you understand the ins and outs of the director’s loan account? Gareth Burrow, senior manager at UHY Calvert Smith, explains.
If you own a company, the director’s loan account may seem like yet another mysterious number conjured up by your accountant, or complex financial jargon on a par with deferred taxation and goodwill amortisation. However, ignoring the director’s loan account could result in an unnecessary tax bill for your company and its directors, and failure to properly get to grips with it could mean you miss out on important planning opportunities.
Understanding the director’s loan account
In a nutshell, a director’s loan account records the amount of money that is owed to the company by its directors, or vice versa.
It does not arise where a director simply receives their salary each month, or when a dividend is paid out in full when declared, because nothing is owed, so the loan account is irrelevant. However, when money is withdrawn from the company, either directly as cash drawings, or when private purchases are made using the company bank account or credit card, this is recognised as an amount owed to the company by the director on their loan account.
Correspondingly, where a director introduces cash into the business, or doesn’t fully withdraw the salary or dividend due to them, this is recognised as a credit on their loan account, because it is an amount payable by the company.
The director’s loan account balance therefore reflects the cumulative movement of the amounts withdrawn and advanced over time. Understandably, it is where the loan account is overdrawn, and the director owes the company money, that more significant tax consequences may develop.
A note on legality
In most circumstances, there are very few practical legal issues connected with an overdrawn loan account for the director of a private, owner-managed company. However, problems can arise, particularly in the event of a shareholder dispute, or if the company gets into financial difficulty. So having the appropriate paperwork and shareholder approval in place is strongly advisable.
Bear in mind that company law and accounting standards also require specific disclosure of the director’s loan account in financial statements.
Tax implications of the overdrawn loan account
HM Revenue and Customs (HMRC) is particularly interested in an overdrawn director’s loan account, as it represents cash taken out of the business that hasn’t been taxed. HMRC addresses this in two main ways:
25% tax charge
A company is generally required to pay a tax charge of 25% on the outstanding overdrawn balance on the loan accounts of directors/shareholders (and that of their family or other associates) at the end of its financial year, unless it is repaid within 9 months.
Although this 25% (Section 455) charge is calculated and paid as part of corporation tax, it is not a tax in the usual sense, as HMRC will normally refund the charge as the loan is cleared. The major issue is therefore likely to be one of cash flow, as it will be at least 12 months before the company receives its repayment.
Benefit in kind charge
A benefit in kind charge may also arise on the loan, assuming that it is interest-free and calculated on the basis of the notional interest (currently 3.5%), which would have been payable on the overdrawn balance over the tax year. The director will personally pay income tax at the marginal rate on the calculated value of any such benefit, and the company will also pay Class 1A national insurance (currently 13.8%).
6 practical tips and planning points:
- Declaring dividends at regular intervals throughout the year, rather than annually, may help to avoid, or minimise, an overdrawn loan balance.
- HMRC has detailed anti-avoidance rules designed to combat perceived manipulation of the repayment conditions for the Section 455 charge. Take particular care in relation to the timing of any drawings made from the company after a repayment.
- The overall tax situation of the directors and company should be assessed, rather than simply prioritising repayment of the loan account. For example, it may be better to suffer the temporary cash flow disadvantage of the 25% charge than take an action that will move a director into the top rate of income tax.
- Where the company has sufficient cash reserves to provide the option, you could find that the tax cost of taking a loan from the company may be lower than the interest and related charges incurred in borrowing personally from a lender.
- A benefit in kind charge, from the 2014/15 tax year, will only arise where your total individual loan amount outstanding exceeds £10,000 at any point in the tax year. This may provide tax planning opportunities.
- As an owner-manager, you can extract a certain level of profits from your company at a low overall tax cost. By crediting salary and dividend to the loan account, you may be able to take advantage of this when it is not possible, or beneficial, to withdraw the actual cash from the company due to cash flow constraints.
About the author
Gareth Burrow is a senior manager at UHY Calvert Smith in York, part of the UHY Hacker Young top 20 national accountancy network. Gareth provides advice and support to owner-managed businesses, with a particular technical focus on financial reporting, audit, and other specialist compliance services. You can follow UHY Hacker Young on Twitter @uhyhackeryoung.