Overdrawn Director’s Loan account

What is a director’s loan account?

When businesses are owned and run by the same person (the director is a shareholder) there are very often transactions between the company and the director. This could be the director initially putting money into the business to start it up, or injecting some cash when the company needs it. These sorts of transactions create something called a director’s loan account.

It may also be for wages that have been declared to HMRC but not yet taken, or expenses incurred by the director personally but not yet refunded to them.

The above are all transactions that increase the amount of money that the company owes the director.

However there are transactions that can send the balance in the other direction – simply drawing money out the business without declaring a dividend, or having the company the company pay for something personally for you. These are all obvious types of transaction which will either reduce the amount owing to the director, or will mean that the director actually owes the company some money.

There are other sorts of transactions that can sneak up on directors – illegal dividends are the most obvious transaction we see – where a director has paid more in dividends to themselves that company law allows them to – this would put the dividend in a repayable position.

The typical scenario is where the director has been only really paying attention to the bank account and paying themselves what is in the bank, forgetting that corporation tax is also due (this is incredibly common!)

Should the director owe the company money there are a variety of tax implications that apply.

A history of (tax) abuse

To understand the tax implications of the tax on an overdrawn director’s loan account its useful to know the context and history as to how it arose.

In the past some less that scrupulous directors would attempt to avoid paying income tax (or corporation tax) by lending themselves a large amount of money. As the money was a loan there was not income tax paid on it. This amount would continue to rack up until the directors decided to wind the company up, chalk the director’s loan as a bad debt, write it off and wind up the company.

The directors have the cash, and no impact was due. In our view this was never strictly legal but non-the-less did happen.

Section 455

To combat this HMRC brought in legislation that put the tax burden on the company – what is know as section 455. This means if there is a director’s loan balance outstanding at the year end the company has to pay tax at 32.5% on the increase in that loan. This was intended to ensure that HMRC got the tax even if the company subsequently was wound up.

There are a lot of rules around this, including the ability to get that amount back if the loan is repaid, or income tax paid on it.

Benefit in kind

On top of this s455 there is also something known as a benefit in kind that needs to be considered as well.

HMRC take the view that if you are borrowing money from the company, and not paying any interest on that money you are getting a benefit from the company and should therefore pay tax on the value of that benefit.

Thankfully this is quite a low level of benefit – the benefit is considered to be the tax you have not paid, which given the current official rate of 2.5% means that the overall tax you pay on this is often not all that much. On a £20k loan that interest should have been £500. Income tax at 40% would mean a tax charge of £200.

There is also a national insurance consideration that the company needs to pay on benefits in kind – Class 1a charged at 13.8% on the £500 totalling £69 (this £69 is tax deductible for corporation tax purposes so in reality works out to only cost £55.89). So on a loan of £20k a director might pay £255.89 per year.

The key issue with the benefit in kind that many directors find is not the cost, but remembering to do it, or paying an accountant to file the P11d form at the end of the year.

What Can I do about it?

With an overdrawn director’s loan account there are limited remedies, and non that are pain free.

Here are a range of options

• Repay the loan – if it’s under £10k you may be able to repay it then draw it back out shortly after – what is known as bed and breakfasting. This, however is not recommended as there are rules in place to combat it
• Declare a “paper dividend” to clear the director’s loan account. This is where you declare a dividend, but pay no cash to yourself. The real sting in the tail is that, despite having not cash from the dividend, you will still need to pay dividend tax. You can only do this if you have sufficient “distributable reserves” to do so (basically profit not yet paid as a dividend).
• Declare a bonus to clear the director’s loan account. This is the same as the above option for times where there are not sufficient distributable reserves. You will pay income tax, national insurance and the company will pay employers national insurance on this so its quite expensive.

Here are some things you can’t do

• Ignore it – simply – that would be illegal (tax evasion, which once you do anything with it then becomes money laundering – all very serious)
• Wind the company up – HMRC would have the right to object and appoint a liquidator. They would come after you personally for the money.

Director’s loans can get quite complex so its important to account for things well and get it right. Cloud accounting software can be a real help with this (FreeAgent is particularly good for this), as can having an accountant who is alert to this issue.

Ultimately, setting up your business in an efficient and structured way can help considerably to keep you organised. Simply being aware of the issue and avoiding making any large dividends at the end of the year often helps.

There is more information to be found here