Most business owners trade through a Limited Company and almost every director of a limited company will have a loan account with their company. But very few will understand what this is and the rules and tax implications surrounding this strange concept.
To understand what a director loan account is, lets first look at the difference between a limited company, and a sole trader or a partnership structure,
The profits you make as a sole trader or through partnership are taxed on the individual in the period the profits are generated whether profits are drawn by the business owner or not; there is however no further tax charge on the owner or partner when they draw profits out of the business. Depending on the level of profit and other factors, a sole trade or partnership structure tends to be more expensive in terms of the overall tax and NIC liability on the owner; the highest tax rate being 45% plus NIC!
A limited company on the other hand is a separate legal entity, and the business owner will generally be a director (employee) of the company, and also a shareholder. The overall tax benefit of a limited company has been reduced in recent years but they still provide a lot more flexibility as to when some of the tax is paid. Profits generated by the company are taxed in the company in the period that they are made (currently at 19% whatever the level of profit, which is relatively cheap) HOWEVER there is a further tax charge on the individual when drawing profits out of the Company.
There are three ways in which a business owner can draw profits out of a limited company:
1. Salary – most directors draw a basic salary from their company either at the NIC threshold or the personal allowance threshold of £12.5k as no tax at that level subject to other sources of income (there is a small NIC charge). This salary is allowable against the profits of the company thereby reducing the 19% tax charge.
2. Dividends – Payments to Director / shareholders from after tax retained profits. These are taxable at 7.5% for a basic rate tax payer, 32.5% for a higher rate tax payers and 38.1% for high earners. Each shareholder also has an annual dividend allowance so the first £2k is tax free. Dividends are normally paid quarterly, bi-annually or annually and must be documented properly. However, you can only pay a dividend from retained profits and if a dividend is declared without sufficient profits, this is illegal. It is therefore advisable to have management accounts to back up any dividend decision. If management accounts are not available, then it is advisable to classify a payment made to a director / shareholder as a loan, pending a decision on the level of dividend that can be made lawfully.
3. Directors Loan – this where the business owner borrows funds from his company that is not documented and declared as 1 or 2 above. Private expenditure paid through the limited company is also classified as a loan to the director. This is the most common way that a director draws funds from their company. The important point here is that a loan is not taxed at the point it is withdrawn (apart from on the loan interest benefit deemed to have been received if the loan is interest free) whereas a salary and a dividend are taxed. BUT loans can be taxed if not repaid to the company within NINE months of the company accounting period end. The good news is the loans do not have to be physically repaid, but can be repaid by documenting a salary or dividend payment to cancel out the cash loan already taken, a book entry in the accounts.
Your questions answered
What if the loan is not repaid within 9 months?
Then the company pays a holding tax at a rate of 32.5% is payable within 9 months and one day of the end of the accounting period in which the unpaid loan was made. This is repaid to the Company sometime after the end of the accounting period in which the loan is repaid. HMRC are good at collecting taxes but not so quick at refunds so it’s best to avoid this situation if at all possible.
Can I repay the loan just before the year end and then draw it out again shortly afterwards?
Afraid not! Loans redrawn within 30 days are deemed to have not been repaid at all and a tax charge will not be avoided.
Can the Company write off the loan?
Yes, the company can formally write off the loan. The business owner will be deemed to have received a dividend which would be taxed in the normal way.
What happens if the Company fails and I have an outstanding debt to the Company?
An overdrawn directors loan is an asset in the Company’s books. If a liquidator is appointed, then they can seek to recover the director’s loan from the director, but this rarely happens in practice.
As alluded to earlier, having regular management accounts is essential to keep track of your director loans and minimise any tax charges (along with the many other benefits of course) and a virtual FD can help you with this and ensure you declare salary and dividends in a tax efficient, timely and lawful fashion.
If you have any more question on director loan accounts, or want to find out more about evirtualFD and how we can help you and your business, get in touch.