There are various ways in which an overdrawn balance on a director’s loan account may be cleared. In this sample excerpt from the newly updated guide ‘Directors' Loan Accounts Explained’, Sarah Bradford looks at the tax consequences of declaring a dividend to clear the balance.
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Declaring a dividend
The balance on an overdrawn director’s loan account can be cleared by declaring a dividend and crediting the dividend to the account. Alternatively, a dividend can be declared and paid to the director, and the director can then reintroduce the funds back into the company to clear the outstanding loan balance. The tax consequences are the same regardless of which of these routes is taken.
It should be remembered that a company can only pay a dividend if it has sufficient retained profits to do so. Further, a dividend for a particular class of shares must be paid in proportion to the holdings for that class of share. However, where there is more than one shareholder (as may be the case in a family company), having an alphabet share structure (A ordinary shares for one person, B ordinary shares for another, C ordinary shares for another, etc.) creates the flexibility to pay different dividends to different shareholders and thus enables the dividend payment to be tailored to the circumstances.
Regardless of whether a dividend is actually paid to the director or shareholder or credited to the director’s loan account, the dividend will be taxed in accordance with the rules for taxing dividends.
All taxpayers, regardless of their marginal rate of tax, receive a dividend allowance. This was set at £1,000 for 2023/24 but is to fall to £500 for 2024/25. The available dividend allowance should be taken into consideration when determining the timing of a dividend.
Although it is called an ‘allowance’, the dividend allowance is not an allowance, as such, but rather a zero-rate band that applies to the first slice of taxable dividend income. Any remaining taxable dividend income (treated as the top slice of the taxpayer’s income) is taxed at the dividend ordinary rate to the extent that it falls within the basic-rate band, at the dividend upper rate to the extent that it falls within the higher-rate band, and at the dividend additional rate to the extent that it falls within the additional-rate band. The dividend allowance counts as part of band earnings.
For 2023/24 and 2024/25, the dividend ordinary rate is set at 8.75%, the dividend upper rate is set at 33.75% and the dividend additional rate is set at 39.35%.
Example 14: Declaring a dividend to clear an overdrawn director’s loan account
Kevin is the director and shareholder of his personal company. The company prepares accounts to 31 March each year.
On 31 March 2024, Kevin’s director’s loan account showed an outstanding balance of £30,000. He had taken out a loan of £30,000 in July 2023. The company declares a dividend of £30,000 on 30 June 2024. The dividend is credited to Kevin’s director’s loan account, clearing the overdrawn balance.
As the overdrawn balance is cleared within nine months and one day of the year end, there is no section 455 tax to pay. However, as the account was overdrawn at the end of the accounting period, the overdrawn balance must be declared on the corporation tax return.
The dividend is paid in the 2024/25 tax year. The first £500 of the dividend is covered by the dividend allowance and is taxed at a zero rate. Kevin has other income in 2024/25 of £12,570, which uses up his personal allowance. The balance of the dividend after using the dividend allowance is taxed at the dividend ordinary rate, set at 8.75% for 2024/25; the tax payable is, therefore, £2,581.25 ((£30,000 – £500) @ 8.75%).
Had the dividend been declared before 6 April 2024 (say on 4 April 2024), and if Kevin had not used his dividend allowance for 2023/24, he would have been able to receive £1,000 of the dividend tax-free rather than £500. He would also have his 2024/25 dividend allowance of £500 still available. However, the tax would be due a year earlier.
If the company had not declared a dividend and the loan had remained outstanding at the section 455 trigger point, this would have resulted in section 455 tax of £10,125 (£30,000 @ 33.75%). By declaring a dividend to clear the loan, the total tax bill is reduced in this case. This is because some of the dividend is taxed at a zero rate and some at the ordinary dividend rate of 8.75%. The tax on the dividend will be paid by the director personally; if there is section 455 tax to pay, this is payable by the company.
The company may need to declare a dividend that is larger than the outstanding loan balance to provide the director with the necessary funds to pay the tax due on the dividend.
In this case, crediting the £30,000 dividend to the director’s loan account will clear the overdrawn balance, but the director will need to find the funds to pay his personal tax bill on the dividend of £2,581.25 if the dividend is paid on or after 6 April 2024 (or £2,537.50 if the dividend is paid before that date).
To provide the director with sufficient funds to meet the tax on the dividend used to clear the loan, if the dividend is paid on or after 6 April 2024, it will be necessary to declare a further dividend of £2,829 (£2,581.25 x 100/91.25), on which dividend tax of £247.54 (£2,829 @ 8.75%) will be payable, leaving the director with the necessary funds of £2,581.46 to pay the tax on the dividend of £30,000.
Even allowing for the need to pay a dividend in excess of the outstanding loan balance, where the dividend is taxed at the dividend ordinary rate, it is cheaper to declare the dividend and pay the associated tax than to pay the section 455 tax.
However, had Kevin already used his basic-rate band and dividend allowance, so that the dividend was taxable in full at the dividend upper rate, it would be cheaper to pay the section 455 tax than to declare a dividend that would be sufficient to clear the loan and pay the tax on the dividend. The company would need to declare a dividend of £45,283 on which the director would pay tax of £15,283, leaving £30,000 to clear the loan. The tax payable by the director on the dividend of £15,283 is higher than the section 455 tax of £10,125 that the company would pay on the outstanding loan balance.
It would also be cheaper to pay the section 455 tax if Kevin was an additional-rate taxpayer, as the dividend would be taxed at 39.35% in his hands.
The section 455 tax has the added advantage of being repayable if Kevin is able to clear the loan in a more tax-efficient manner (for example, by introducing personal funds into the company) in the future.
NICs
There is no National Insurance to pay on dividends.
Practical tip
Where the company has sufficient retained profits, it may be possible to declare a dividend to clear an overdrawn director’s loan account and to prevent a section 455 tax bill from arising. However, this will not always be the best option and, in certain circumstances, it may be preferable to pay the section 455 tax in the first instance if this is lower than the tax that would be payable on the dividend. This will be the case if all or some of the dividend is taxable at the additional rate, particularly if the director is likely to be able to clear the loan more tax-efficiently at a later date (for example, using funds from outside the company). See section 8.
It may also be preferable to pay the section 455 tax if the dividend is taxed at the upper dividend rate, the dividend allowance has already been used and it is necessary to declare a dividend higher than the outstanding loan balance in order to provide sufficient funds for the director to pay the tax on the dividend.
Beware
To ensure that the director has sufficient post-tax funds available to clear the director’s loan account balance and meet the associated tax bill on the dividend, the dividend declared may need to be more than the outstanding loan account balance. Where funds are needed to both clear the loan and cover the tax on the dividend, the outstanding loan balance (which is to be cleared by the dividend) will need to be grossed up to take account of the tax payable on the dividend. The grossing up calculation will depend on the rate at which the dividend is taxed and whether the dividend allowance remains available.
For illustration purposes, if the dividend allowance and personal allowance have already been utilised and the dividend is taxed at the dividend upper rate of 33.75%, it will be necessary to pay a dividend of £15,095 to clear a loan of £10,000. The dividend tax at 33.75% on a dividend of £15,095 is £5,095, leaving a post-tax balance of £10,000 to clear the loan, and providing the director with the funds to pay the tax on the dividend. The gross dividend is simply £10,000 x 100/(100 – 33.75).
If the director is an additional-rate taxpayer who has used both their personal allowance and their dividend allowance in full, a dividend of £16,488 (£10,000 x 100/(100 – 39.35)) will be needed to clear the loan balance and pay the dividend tax of £6,488 (£16,488 @ 39.35%) on the dividend.
