IT contractors’ guide to borrowing company money
The facts behind the Directors Loan Account
Taking money from the business for personal use when trading as a partnership or sole trader is fairly straightforward and, unless there is a drain on company assets, there are generally no tax implications.
A limited company, however, is a separate legal entity and therefore making withdrawals from the company requires far more consideration.
In this ebrief, Intouch Accounting, the personal online accounting adviser for contractors and freelancers, looks at the consequences of an
overdrawn director’s loan account and how the impact can be reduced, or even avoided.
Director’s loan accounts can incur a tax cost for the unwary, so read on and make sure you don’t get caught out.
What is a Director’s Loan Account?
The Directors Loan Account (DLA) is a nominal account on the company account’s balance sheet that records all transactions between the director and the company. The balance at any one time may be in credit and owed (CR) to the director by the company, or overdrawn (DR) and owed by the director to the company.
A credit DLA balance is recorded in the accounts as a liability, meaning the director is a creditor to the company. A debit balance is an asset and therefore the director is a debtor to the company.
The loan account is a record of:
Amounts due to the director, such as:
- Loans or cash advances the company has received from the director.
- Their entitlement to receive net salary, bonus or deemed salary (under IR35),or dividends as a shareholder.
- Company expenses the director has paid personally.
- The value of assets the director has provided to the company.
Amounts due from or paid to the director, such as:
- Money paid from the company on account of net salary, bonus or deemed salary (under IR35).
- The repayment of company expenses paid personally by the director.
- Other personal bills paid by the company that are not treated as a benefit in kind (BIK).
- Loans or other advances made to the director by the company.
- Unpaid capital on shares issued to the director.
Ideally the Directors Loan Account should be in credit!
But what does it mean when the Directors Loan Account is overdrawn?
If the DLA is overdrawn, the director has taken more money from the company than he is entitled to at that time.
The DLA may become overdrawn for a number of reasons. The most common one is where money is withdrawn from the company to meet day-to-day living expenses before any bonus or dividends have been formally declared. Other reasons may include the excessive use of company money to pay personal expenditure, or the company lending money to the director, short term or otherwise.
Should interest be charged on loans?
Where the DLA is in credit, the director has an option to charge the company interest on the amount that is owed to him. If the company incurs this expense, it must deduct 20% withholding tax before paying it to the director. This is reported quarterly using form CT61 to HM Revenue & Customs (HMRC).
The company receives Corporation Tax relief on that cost. However, the director must also declare the interest as income and will be subject to personal Income Tax if earnings exceed the lower rate tax band.
Where the Directors Loan Account is in credit, the director has an option to charge the company interest. If the company incurs this expense, it must deduct 20% withholding tax before paying it to the director.
Conversely, the company may charge the director HMRC-approved interest rates if the DLA is overdrawn. This is additional profit on which the company will pay Corporation Tax
However, the director will not receive personal tax relief on the interest charged. If the company does not charge interest, then HMRC perceive this to be an interest free loan and therefore a Benefit In Kind (BIK) arises for which the director will be subject to personal Income Tax, and the company subject to Class 1a National Insurance contributions (NIC) on the deemed interest on the loan.
But what’s wrong with an overdrawn DLA?
An overdrawn Directors Loan Account creates a number of problems:
Is it legal?
The Companies Act 2006 generally says that a company may not make a loan to a director unless it’s either less than £10,000 or the shareholders have approved the loan beforehand, having been provided with all the relevant facts in a board meeting and recorded it in the minutes
Let’s be honest, that’s not really a problem. Often a director is also the controlling shareholder, so it’s more a formality that must be followed if the loan is to be legal.
It’s subject to a tax charge
A DLA might look like an easy way to take money from the company but HMRC is not blind to this possibility, so it’s no surprise that they will want to tax someone. They can’t treat the loan (overdrawn DLA) as personal income, because it’s repayable to the company, so they have a special set of rules they use in these circumstances.
Where an overdrawn DLA remains outstanding nine months after the end of the company accounting year HMRC will charge the company tax at a rate of 25% on that amount, known as Section 455 Tax (referring to the section number in the relevant legislation). It makes no difference that the company has made profits and has paid tax on those profits, or even if it’s made losses and pays no tax; the S455 tax on the overdrawn DLA is still payable, and is due at the same time as any normal company tax – nine months and 1 day after the end of the accounting period.
Where an overdrawn DLA remains outstanding nine months after the end of the company accounting year, HMRC will charge the company S455 Tax of 25% on that amount.
When the director repays the loan back to the company, HMRC will also repay the S455 Tax. This won’t be paid back however until nine months and 1 day after the end of the accounting period in which the loan is repaid (the normal due date for any tax that would be due too).
The company advances a director £10,000 on 31 March 2013, the accounting year end of the company. On 30 June 2013 the director repays £5,000, leaving £5,000 outstanding
On the 31 December 2013 the £5,000 balance still remains outstanding, and so the company must pay S455 of £1,250 on 1 January 2014, being 25% of the loan balance.
On 31 July 2014 the balance of the loan was repaid, which falls into the accounting year ending on 31 March 2015. HMRC will repay the £1,250 S455 on the normal tax due date for that year, being 1 January 2016. This is 17 months after the debt was repaid.
You must write to HMRC to request repayment, and keep proof of the original S455 tax that you paid as HMRC are under no obligation to keep records of S455 payments themselves!
An overdrawn DLA is a benefit in kind
HMRC will treat a loan made to a director as a benefit in kind (BIK), unless interest has been charged at the official rate or higher, because the director has gained a benefit by not going to a commercial lender and getting a loan on normal commercial terms
Small loans resulting in a DLA balance of £5,000 or under, increasing to £10,000 from 6th April 2014, are however ignored by HMRC. Only amounts above this are regarded as significant enough to warrant considering as a benefit in kind.
The value of the benefit is calculated by multiplying the loan by the official rate of interest, which varies from time to time and can be found on the HMRC web site at www.hmrc.gov.uk/rates/interestbeneficial.htm.
Small loans resulting in a director’s loan account balance of £5,000 or under, increasing to £10,000 on 6th April 2014, are ignored by HMRC. Only amounts above this are regarded as significant enough to warrant considering as a benefit in kind.
There are two ways of calculating the benefit in kind value that produce the same result where the amount outstanding remains constant; however that’s rarely the case in the real world!
The averaging method
This method takes the balance due on 6 April (at the beginning of the tax year) and the balance due on 5 April (at the end of the tax year) and applies the official interest rate on the averaged amount.
The daily method
This method records the detailed movements of the amounts due and works out daily interest on each amount. This is a more complex calculation and often results in a higher benefit in kind amount. HMRC can insist this method is used if the averaging method results in an unfair representation of the loan, for example if a loan starts at £1,000 on 06/04/2014 then increases to £50,000 for 11 months before dropping back down to £1,000 for 05/04/2015 – under the averaging method the benefit in kind balance is £1,000!
The benefit in kind amount is reduced by any interest paid by the director
Do these rules apply to anyone other than a director?
The simple answer is yes.
Thinking that tax can be avoided by lending company money to a spouse etc. is sadly never that simple! Loans made by a small company which qualifies as a “close company”, being one that is under the direct or indirect control of 5 or fewer people (known as participators), will fall under these rules. Even lending money to another company that in turn lends the money to you will fall under the rules.
Participators will include directors and shareholders but also may include, even by association, a spouse or civil partner, business partner, relative, trustee, or a loan creditor.
But how does HMRC find out about an overdrawn Directors Loan Account?
There are three ways that HMRC is notified of the existence of loans made to directors (or participators for that matter).
- The company accounts must disclose details of transactions between the company and its directors, shareholders and their immediate families. The notes to the accounts disclose the nature of the transactions, the loan amounts due at the beginning and end of the accounting period and the maximum amount outstanding.
- The company must file a Corporation Tax Return (CT600) each year with HMRC that reports the existence of any outstanding loans and all repayments made.
- The company must file an annual P11D and P11D(b) which require disclosure of the benefit in kind on all interest free loans made by a company.
Is there a way to offset the Directors Loan Account?
Some companies have two directors, often husband and wife, civil partner or similar. It is possible for one director to owe money to the company, whilst the other is owed money
These balances may not be arbitrarily offset against one another to avoid a S455 or BIK liability. However, the directors can formally agree that the balances are offset, effectively meaning the overdrawn balance is repaid against the balance previously owed.
Any formal offset agreements should be clearly documented and signed by both parties as they may be examined by HMRC.
What about Directors Loan Account and IR35?
Where the contract is subject to IR35 the final deemed salary is not usually known until a detailed calculation is made after the end of the tax year. Some contractors take an estimated amount of money on account of the expected final salary each month, without actually declaring it as salary to HMRC. This approach has implications for the balance on the DLA as the payments will create a loan due to there being no payroll summary in place to match the money being taken.
If you’re subject to IR35 the only way to avoid the creation of a loan is to set a reasonable salary each month sufficient to cover your day-to-day needs, so that you don’t need to withdraw additional funds in excess of that.
This raises an interesting point: when does a transaction appear on your DLA?
In most cases it’s the date of the payment or receipt, for monthly salary the date the salary is payable, but what about dividends, deemed salary under IR35 and other bonuses or end of year salary amounts?
Dividends and the Directors Loan Account
Dividends are payable on the date they are declared. From a tax perspective the dividend falls into the tax year the dividend is “unreservedly due to be paid” to the shareholder.
An overdrawn DLA can be reduced by a dividend, but that reduction only happens on the date the dividend is declared. You cannot declare a dividend to retrospectively clear an overdrawn DLA, so you must keep an eye on the loan balance throughout the year rather than simply reviewing it after your accounts have been prepared.
These same rules can be beneficial for you though, as they can be used to adjust the tax year in which dividends are deemed to be received as a means of managing higher rate taxes
An overdrawn DLA can be reduced by a dividend, but that reduction only happens on the date the dividend is declared. You cannot declare a dividend to retrospectively clear an overdrawn DLA.
An example will help to explain how this can work
Let’s assume that the company year-end is 31 July and that it has made £50,000 profit after Corporation Tax. The director’s salary from the company is £12,000 and this continues annually.
During the year ended 31 July 2014, £4,000 a month in addition to the salary is paid by the company to the director. A dividend has not been declared and the DLA is £48,000 overdrawn.
If a net dividend of £48,000 was declared on 31 July 2014 and credited to the DLA, the director’s gross income in the 2014/15 tax year would be £53,333 (£48,000 / 0.9). Add that to the salary and the director is pushed into the higher rate tax band.
In this example, there would not be any S455 Tax due, as the dividend has repaid the overdrawn DLA before 30 April 2015.
One strategy would be to declare some dividend to clear part of the loan so that the combined personal income (salary and dividend) falls within the basic rate tax band, leaving the balance to be cleared by a dividend declared between the 6 April and 30 April 2015.
Therefore, a dividend of £28,000 is declared at the year-end reducing the overdrawn loan account to £20,000, leaving the outstanding balance until 20 April 2015 when a second dividend of £20,000 is declared to clear the loan.
The result is that the second dividend is pushed into the new tax year and higher rate tax has been avoided and the S455 Tax on the overdrawn loan account is not due because the overdrawn DLA is repaid before 30 April.
There will be a BIK on the interest free loan, however, it will be considerably less than the higher rate Income Tax liability on the dividend of £20,000
When carefully monitored, this example shows that, with advanced planning, dividends declared during one company year that are straddled over two tax years can result in higher rate tax savings.
A note about illegal dividends
Dividends can only be paid from profits, which is the company net sales less expenses less a provision for the taxes that will fall due, plus any profits brought forward from prior years. It is never as simple as the balance in the company bank account, so do not assume that bank balance is available for you to take as a dividend.
Talk to your accountant and review your management accounts before declaring a dividend.
When a dividend is declared that exceeds the company’s available profit, it will be an illegal dividend and should be treated as a loan to the shareholder. Declaring illegal dividends is a sure way of creating an overdrawn loan account and all the tax implications that come with it.
What are the dangers of illegal dividends and an overdrawn DLA?
If a dividend is illegal it means the company does not have the funds to pay it plus still be able to settle all its liabilities, such as company taxes. This is turn means that the shareholder has to repay the loan to the company before the company will have the funds available to pay the taxes due.
Many contractors get themselves into trouble by paying illegal dividends and then not being able to repay the loan that it creates. When HMRC ask for their tax, the company then cannot pay it……
So, what happens?
The company may have to go into liquidation. It is the liquidator’s job to seize and collect the assets of the company and pay whatever amount is available to the creditors (HMRC). The company has one big asset, the director (the amount owed to the company in the overdrawn DLA), and unfortunately the liquidator will pursue the director to repay this debt
Do not assume the bank balance is available for you to take as a dividend. Talk to your accountant and review your management accounts before declaring a dividend.
Can an overdrawn loan account be written off by the company?
Yes, but there will be tax implications.
An overdrawn DLA that is written off is treated as a distribution and becomes subject to personal Income Tax and NICs for the director (or participators) and is declared in their personal tax return.
Despite the written off overdrawn DLA being taxed on the director, the company will not receive Corporation Tax relief on the written off debt.
As with a loan from a bank, a DLA will need to be repaid at some point in time. Good record keeping is therefore essential. Poor records may result in the misallocation of expenses and payments and, ultimately, the right taxes not being paid. Even a business previously thought to be resilient can find itself in an insolvent position if care is not taken. So, remember these top tips and, if the profits aren’t there to declare a dividend, don’t declare one … and don’t take a loan unless you know that you are going to be able to pay it back.
Where the company owes money to a director or a shareholder it’s just a normal liability that the company must repay at some time. When it does repay the debt there are no special tax issues to be considered.
Where the director owes money to the company this has 2 tax implications:
- The company will have to pay an additional 25% S455 Tax on any amount outstanding at the end of an accounting year, if any part of that loan remains outstanding nine months after that accounting year end.
- If the amount of the loan exceeds a certain amount during the tax year then the director is deemed to have an interest free loan and a BIK is calculated and taxed as income and also subject to Class 1A NICs.
Any loans exceeding £10,000 are strictly illegal if the shareholders have not specifically approved them.
Don’t take out a loan during an accounting year and then repay that loan before the nine month deadline after the year end, only to then borrow the same again a few days later and repeat the cycle. HMRC is wise to this little trick and will deem the loans to be one transaction (it’s known as bed & breakfasting).
Dividends, salary and a DLA can be constructively used to mitigate higher rate taxes, but only in the right, controlled circumstances.
Writing off a director’s loan is expensive from a tax point of view – unless you have died … and that’s a little too drastic!
Be very careful not to take too much money from the company, leaving the company unable to pay its debts. A Liquidator will come after you!
If you require further information on this or any other contractor related matter, speak to your contractor accountant who will advise you of your options and provide you with the right information that’s relevant to your specific circumstances.
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